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THE .UNIVERSITY OF CHICAGO 
STUDIES IN ECONOMICS 


PUBLISHED UNDER THE DIRECTION OF 


THE DEPARTMENT OF ECONOMICS 



V 






l 



I 




STUDIES IN THE ECONOMICS 
OF OVERHEAD COSTS 


THE UNIVERSITY OF CHICAGO PRESS 
CHICAGO, ILLINOIS 


THE BAKER & TAYLOR COMPANY 

NEW YORK 

THE CAMBRIDGE UNIVERSITY PRESS 

LONDON 

THE MARUZEN-KABUSHIKI-KAISHA 

TOKYO, OSAKA, KYOTO, FUKUOKA, SENDAI 

THE COMMERCIAL PRESS, LIMITED 

SHANGHAI 




STUDIES IN THE ECONOMICS 
OF OVERHEAD COSTS 


BY 

J. MAURICE CLARK 

PROFESSOR OF POLITICAL ECONOMY 
AT COLUMBIA UNIVERSITY 



THE UNIVERSITY OF CHICAGO PRESS 
CHICAGO, ILLINOIS 












UBh'i 




COPYRIGHT 1923 BY THE UNIVERSITY OF CHICAGO 
ALL RIGHTS RESERVED. PUBLISHED DECEMBER 1923 
Fourth Impression October 1931 


COMPOSED AND PRINTED BY THE UNIVERSITY OK CHICAGO PRESS 
CHICAGO, ILLINOIS, U.8.A. 


AM 0^6 







TO MY FATHER 





PREFACE 


This volume is a bit of research into the principles of dynamic 
economics. It is an experiment in a type of economic theory 
which is largely inductive, which comes to grips with the dynamic 
movements and the resistances to movement, and the organic 
interrelations of parts, which make our economic world a dynamic 
social organism, rather than a static mechanism with an endless 
uniformity of perpetual motion. It studies the discrepancies 
between supply and demand; indeed the whole subject of the 
book might be defined as a study of discrepancies between an 
ever fluctuating demand and a relatively inelastic fund of pro¬ 
ductive capacity, resulting in wastes of partial idleness, and many 
other economic disturbances. Unused capacity is its central 
theme. 

This subject, of costs which are not traced to units of output, 
or do not vary with output, has challenged the author’s scientific 
interest for years. From being a mere exception to the general 
laws of value and efficiency it has grown to be a large and impor¬ 
tant section of economic principles. And now the question 
seems to be whether it can best function as an autonomous 
department of economics, or whether the whole body of economic 
thought must become an “economics of overhead costs” in the 
sense of being integrally built upon this as a part of its founda¬ 
tion. In the latter case, the new groundwork would need to 
include many other equally important and equally fundamental 
facts of human nature and industry, all of which together 
would furnish an adequate and convincing background for a 
picture of the dynamic, organic, and social qualities of our 
industrial life. 

The author has sometimes said that a graduate class in 
economic theory would be a success if the students gained from 
it a real understanding of the meaning of cost in all its many 
aspects. He believes that the economist may well study the 


X 


PREFACE 


accountant’s conceptions of cost, since they constitute economic 
forces which affect the conduct of business and the laws of value 
and production. But he believes just as strongly that the 
accountant should know the meaning of cost from the standpoint 
of disinterested economic science, because it embodies, in a sense, 
that impossible goal to which his practical devices serve as 
approximations. Thus one task of this work has been to try 
to throw the light of these two conceptions upon each other— 
with what success the reader must determine. 

A word of explanation may be in order as to why this bit of 
experimental research in economic theory should appear in a 
series of “Materials for the Study of Business.” The funda¬ 
mental reason is twofold. The author of the book believes in 
carrying theoretical study into the realm of those facts and 
forces with w r hich business is consciously in contact (as it is often 
not consciously in contact with the traditional abstract levels of 
long-run equilibrium) and generalizing upon that great wealth 
of inductive material which is accumulating at an ever increas¬ 
ing rate and for which our schools of business are so largely 
responsible. And the editors of this series believe that a study 
of the laws of industry from the broadest social standpoint, and 
from the standpoint of the search for useful truth of whatever 
color, is a vitally necessary part of business education. And 
such a testimonial to the practical worth of theoretical study 
is, to say the least, worth accepting on behalf of theoretical 
economics. 

While the book was not originally planned as a commercial 
text, the material has been used as the basis of a course in which 
students of the School of Commerce have participated, along 
with students in the Department of Political Economy. The 
course has been given three times, the students have contributed 
valuable data and an invaluable service of criticism and dis¬ 
cussion, and the professor’s resignation has not yet been 
requested. In fact, he has been strengthened in the conviction 
that a course covering this subject-matter fills a very important 
niche in any university curriculum and he looks to see such 
courses become fairly numerous in the near future. 


PREFACE 


xl 


The author has tried to put the argument in such form that 
business men would find it readable, if they were willing to deal 
with some few unfamiliar terms and to accept the standpoint 
of a search for the laws of economic efficiency in the large, 
rather than of that narrow commercial efficiency which breeds 
the convulsions that sap the strength of business as a whole. 
Such readers might do well to omit chapter xxiii, dealing with the 
theory of marginal productivity, but it is the author’s earnest 
hope that they will find the bulk of the argument worthy of their 
attention. The subject it deals with, especially the discrep¬ 
ancies between commercial and community measures of efficiency, 
is as important as any which is before us today, and the impor¬ 
tance of the theme may make up for shortcomings in the author’s 
presentation. 

Grateful acknowledgments are due to more individuals than 
can be named. First of all to my wife, whose suggestions have 
had more value than she would admit, whose probable comments 
have been constantly in my mind, affecting the form of the entire 
work, and who has devoted to it an amount of toil which can 
never be adequately recognized by that too conventionalized 
reward of the author’s wife, a mention in the Preface. I have 
also profited by discussions of particular phases of this work with 
my colleague, Professor Jacob Viner, and my former colleague, 
Professor F. H. Knight, now of the University of Iowa. Pro¬ 
fessor J. 0. McKinsey of the School of Commerce and Administra¬ 
tion of the University of Chicago kindly read and commented 
on one part of the manuscript. Acknowledgment is also due 
to the members of the classes who have worked with me over 
this material, and to the entire group of teachers and students 
at the University of Chicago, whose spirit of realism and intimate 
contact with economic facts have furnished a mine of suggestion 
and a salutary corrective for the overabstract tendencies of the 
theorist. 

As for the many writers who have written on one phase or 
another of this subject, partial acknowledgment is made in the 
course of the text, though no one can ever know all the influences 
which have helped form his ideas on any large subject. The 


Xll 


PREFACE 


greatest debt of all is to my father, who started me in this field of 
inquiry as a graduate student, who has followed my work with a 
combination of generous interest and wise refraining from inter¬ 
ference, and to whom this work is dedicated as a very small 
contribution toward realizing his conception of a dynamic 
economics. 

John Maurice Clark 

Carmel, California 
August 29, 1923 



CONTENTS 


CHAPTER PAGE 

I. The Gradual Discovery of Overhead Costs .... i 

II. The Scope of the Problem.17 

III. The General Idea of Cost and Different Classes of 

Costs. 35 

IV. The Laws of Return and Economy, or the Variables 

Governing Efficiency.70 

V. The Laws of Return and Economy, or the Variables 
Governing Efficiency { Continued ) .86 

VI. How and Why Large Plants Bring Economy .... 104 

VII. Economies of Combination.135 

VIII. Different Kinds of Business Rhythms.149 

IX. Different Costs for Different Purposes: An Illustra¬ 
tive Problem.175 

X. What Is a Unit of Business ?.204 

XI. Three Methods of Allocating Costs. 216 

XII. Functions and Chief Methods of Cost Accounting . . 233 

XIII. Railroads and Costs: A Statistical Study .... 258 

XIV. Overhead Costs and Railroad Rate Problems ... 281 

XV. The Transportation System as a Whole.298 

XVI. Public Utilities.318 

XVII. Overhead Costs in Other Industries.335 

XVIII. Labor as an Overhead Cost.357 

XIX. Overhead Costs and the Business Cycle.386 

XX, Discrimination in the Modern Market.416 

XXI. Cut-Throat Competition and the Public Interest . . 434 

XXII. Costs of Government as Overhead Outlays .... 451 

XXIII. Overhead Costs and the Laws of Value and Distribu¬ 
tion . 459 

XXIV. Conclusion.480 

Index of Authors.489 

Index of Subjects . 49 2 

• •• 

2011 


















CHAPTER I 


THE GRADUAL DISCOVERY OF OVERHEAD 

COSTS 

SUMMARY 

Preliminary definition of overhead costs, i—Expenses of production under 
handicraft and domestic systems, i—Discrimination natural, 2—Growth of the 
one-price system, 5—Some early references to overhead costs, 5—Machine versus 
man: how their costs behave, 7—Overhead costs on railroads, 9—Overhead 
costs in other industries, 11—Hadley’s summary of the problem, 12—The con¬ 
tribution of cost accounting, 14—Developments in public utilities, 14—Labor as 
an overhead cost, 15. 


I. PRELIMINARY DEFINITION OF OVERHEAD COSTS 

What are “overhead costs”? The term is nowadays much 
used and variously defined; in fact, it covers an entire fam¬ 
ily of ideas, but they have one essential thing in common. 
They refer to [costs that cannot be traced home and attributed 
to particular units of business in the same direct and obvious 
way in which, for example, leather can be traced to the shoes that 
are made from it. And most of the real problems involve one 
other fact; namely, that an increase or decrease in output does 
not involve a proportionate increase or decrease in cost. There is 
a deal of complexity in the attempts that are made to trace the 
untraceable costs or to assign them on some rational basis, or to 
discover the true added costs of added business, but at the bottom 
of most of these complexities lies a fact that is simple. That 
fact is unused productive capacity, or capacity of which full 
advantage is not taken. “Idle overhead,” that great industrial 
sin, is simply the expense side of this unused capacity. Our 
study of overhead cost will be largely a study of unused powers of 
production. ] 


y 

y 


/ 


2 . EXPENSES OF PRODUCTION UNDER HANDICRAFT OR 

DOMESTIC SYSTEM 

The entire idea of expenses of production is, in a sense, a 
rather recent one. The medieval handicraftsman had occasion 



2 


ECONOMICS OF OVERHEAD COSTS 


to count the cost of his materials, and the merchant the outlay 
for his wares, but his own time he did not pay for, and it was 
not thought of in terms of expense, in the modem business sense. 
With the coming of the wage system, labor became an expense 
of production, paid out by the entrepreneur to someone else. 
More particularly with the domestic system, the employer 
paid the worker not merely for the latter’s time but also for the 
use of his tools and of the premises where he worked. 

The employer’s chief investment was in the materials, so 
that virtually every element which economists now think of as 
an expense of production was paid for in such fashion that each 
item could be directly charged to an item of product. In these 
very special circumstances, expenses were virtually all traceable 
directly to units of product, and overhead expenses were virtually 
non-existent. From the slowness with which economic science 
has assimilated the facts of overhead expense, one is almost 
tempted to conclude that its prevalent ideas on expenses of 
production date back to the domestic system and are not really 
appropriate to any later stage of industrial development. 

3. DISCRIMINATION NATURAL 

Our system of trade is a surprisingly artificial thing, in that 
it is built upon habits and conventions which are, many of them, 
quite recent and which may, many of them, prove to be quite 
temporary. In the same way our economics may be said to be 
artificial, in that it is often tempted to regard these customs 
and conventions as laws of nature. One custom of this sort is the 
custom of selling goods to all customers at the same price. And 
akin to it is the economic doctrine that in a competitive market 
there can be but one price for one commodity at one time, and 
the further notion that the prices of individual commodities are 
governed and definitely determined by their individual expenses 
of production under a competitive system. If one looks at the 
matter historically, one sees that this has never been an accurate 
or adequate description of things and that it has been approxi¬ 
mately true only for a limited period, beginning with the break¬ 
down of medieval guild restrictions and ending with the growth 




GRADUAL DISCOVERY OF OVERHEAD COSTS 


3 


of industries using large fixed capital. And this is but a minute 
fraction of time in the history of the human race and includes 
only the brief infancy of industrialism. 

Even within that period, discrimination in prices has been an 
ever present fact, and, far from being a violation of any natural 
economic laws of competition, it is one of the natural forms which 
competition takes. As for the proposition that under competi¬ 
tion there can be but one price in a market, in manufacturing 
industries there is much stronger ground for holding that under 
competition there must be, chronically or at least intermittently, 
two different prices in the same market. Without this it would 
be difficult or impossible for competition to do its supposedly 
natural work of ironing out profits and bringing prices and 
expenses of production together. 1 Some commodities are so 
standardized and are sold in such well-organized markets that 
differences in price are very nearly eliminated. But even 
with such commodities as steel and oil there are differences 
that are important, small though they may be. 

Discrimination is the natural and universal mode of trade in 
countries which have not reached a stage of modern industrialism. 
It prevails everywhere in the Orient and to a less extent in Europe, 
although the American one-price system is spreading and there 
are stores in Japan and China where one is informed on entering 
that this is a one-price store. The information is very much 
needed, because without it no self-respecting customer would 
think of paying the price asked and no shopkeeper would have 
anything but contempt for the customer who did so. The 
practice of the art of negotiation furnishes the chief interest of 
the game to traders of this type and it is virtually as old as 
trading itself. 

The economics of it is extremely simple. The goods, for the 
most part, are not definitely standardized. The customer does 
not know whether he is being charged more or less than the 
market price, because there is no market price. It is contrary 
to the ethics of this kind of trading to go around openly pricing 
goods in several shops. As for the merchant, he knows what 

1 This point will be taken up in a later chapter. 



4 


ECONOMICS OF OVERHEAD COSTS 


he actually paid for his goods, and he has his living to make. If 
he sells goods, they must ordinarily bring in more than he actually 
spent for them, but his need of an income to cover his living 
expenses goes on whether he makes many sales or few or none. 
If he could be made to understand the modem economist’s 
idea of cost as a reward that must be paid in order to secure the 
service of manager, laborers, shop and wares, he might discover 
that his own time, or his own subsistence, constitutes an over¬ 
head cost, chargeable to his entire business but not chargeable 
to any particular sale. However, not having the advantage of 
contact with modern economics he continues to carry on his 
trade without burdening his mind with unnecessary philosophiz¬ 
ing as to economic reasons for his policy. 

If a particular customer happens to know the market well, 
he will generally get lower prices than one who does not, because 
he will get the full benefit of such competition as exists. Other 
customers will be more in the position of purchasers dealing with 
a monopoly. 

With this system of price discrimination, based upon an un¬ 
analyzed element of overhead cost, organized economic thinking 
seems to have been continually at war, at least down to the last 
quarter of the nineteenth century. Among the ancients the 
value of a commodity was thought of as an intrinsic thing, so 
that a transaction was either at the value of the commodity or 
above or below it, and this lent itself to the idea that if one 
party gained in a trade the other necessarily lost. In medieval 
times it was accepted doctrine that all sales should be at a just 
price and a just price was commonly thought of as that which 
would furnish an income to the craftsman or trader sufficient 
to maintain him in a customary and fitting way, suitable to his 
station in life. It would cover his customary “overhead charges.” 
It is somewhat doubtful how effective the machinery of regulation 
was in practice, whether on the part of guilds or of national 
governments, in controlling the actual levels of prices, but it 
seems probable that it had considerable effect in preventing 
isolated transactions from being made at prices far removed from 
the market. It undoubtedly acted strongly in the direction of a 
one-price system. 


GRADUAL DISCOVERY OF OVERHEAD COSTS 


5 


4. GROWTH OF THE ONE-PRICE SYSTEM 

Modem trade followed the practice of discrimination, though 
perhaps spending less time on the maneuvers of negotiation 
than the merchant of the oriental bazaar. Stores grew in size 
and the selling was done by hired clerks. The owner could not 
generally trust either their knowledge of the goods, their shrewd¬ 
ness, or their devotion to the profits of the business sufficiently 
to delegate to them the diplomatic responsibilities of old-style 
bargaining. Prices were marked on the goods, but in cabalistic 
ciphers, and the salesman’s discretion was guided and limited, 
but not eliminated. Finally came the now-familiar system of 
marking goods in plain figures so that customers could tell 
what the price was without asking the salesman. This prac¬ 
tically coincided with the development of large-scale retailing and 
its economies were obvious. 

It took less time to make a sale and thus enabled more sales 
to be made, and it required less talent and knowledge of the busi¬ 
ness on the part of the salesman. Nowadays, in stores that do 
not stick to one price the price is often still printed in plain 
figures, and the salesperson will call in the manager if it becomes 
necessary to accept something lower in order to make a sale. 
Thus the one-price system means a saving in overhead costs. 
However, far from bringing overhead costs into prominence it 
tends to take care of them automatically by apportioning them 
equally upon all commodities, or at least upon all units of a single 
commodity. Manufacturers and wholesalers, to be sure, do not 
generally follow this policy, but their discriminations appear 
to have been prevailingly regarded as imperfections of the market 
and exceptions to economic law, rather than as natural phe¬ 
nomena whose laws are economic in character and demand study 
by the economist. 

5. SOME EARLY REFERENCES TO OVERHEAD COSTS 

One special case of overhead costs, indeed, was noted by 
John Stuart Mill under “Some Peculiar Cases of Value.” 1 In 
the case of joint products, competition tends to bring the entire 
income of an industry down to cost, but the relative prices of the 

1 Principles of Political Economy, Book III, chap. xvi. 



6 


ECONOMICS OF OVERHEAD COSTS 


different products are whatever may be needed in order to take 
them off the market in the same relative amounts in which 
the joint process turns them out. This case is dismissed in a 
brief postscript to the general theory of value, and the reader is 
left to assume that these are the only cases in which cost of pro¬ 
duction (or custom) 1 is not an adequate explanation of the prices 
of particular commodities. Under unimpeded competition 
there cannot be two prices in the same market. “Yet every 
one knows that there are, almost always, two prices in the same 
market. Not only are there .... cheap shops and dear 
shops, but the same shop often sells the same article at different 
prices to different consumers.” 2 Such prices, Mill said, were the 
result of custom rather than of competition, and since it is only 
by virtue of competition that economics can be a science at all, 3 
such practices are exceptions to law. 

Other writers of this period besides John Stuart Mill gave some 
notice to the facts of overhead cost: notably Torrens, Senior, and 
Karl Marx. Torrens said, in 1834: 

It is self-evident that, amid the ebbings and flowings of the markets 
and the alternate expansions and contractions of demand, occasions will 
constantly recur in which the manufacturer may employ additional floating 
capital without employing additional fixed capital, .... if additional 
quantities of raw material can be worked up without incurring an additional 
expense for buildings and machinery.« 

Senior notes that: 

There are certain expenses upon a mill which go on in the same propor¬ 
tion whether the mill be running short or full time, as, for instance, rent, 
rates and taxes, insurance against fire, wages of several permanent servants, 
deterioration of machinery, with various other charges upon a manufacturing 
establishment, the proportion of which to profits increases as the production 
decreases. 5 

1 Principles of Political Economy , Book II, chap, iv, sec. 3. 

2 Ibid. (Ashley ed.), p. 246. 

1 Ibid., Book II, chap, iv, sec. 1. 

4 On Wages and Combinations (London, 1834), p. 63. Cited by Carl Marx, 
Capital , I, 443. 

5 Report of Inspectors of Factories , October 31, 1862, p. 19. Cited by Marx, 
Capital, I, 443. 


GRADUAL DISCOVERY OF OVERHEAD COSTS 


7 


The large amount of fixed capital “makes long hours of work 
desirable,” 1 and with increased use of machinery, “the motives to 
long hours of work will become greater, as the only means by 
which a large proportion of fixed capital can be made profitable.” 
Karl Marx did not fail to note these damaging admissions and 
use them against the system of private industry. 

But the effect of overhead cost on hours of labor is not so 
simple as these writers supposed; witness Lord Leverhulme’s 
argument that a six-hour day with two shifts is more profitable 
than one eight-hour shift, if only the overhead costs are heavy 
enough! Even where plants work all night, this policy is not 
generally traceable merely to the attempt to economize on 
overhead. The most characteristic and disturbing features of 
overhead costs are concerned with other issues and had not yet 
come into prominence at the time of Marx and J. S. Mill. The 
Industrial Revolution was so strangely slow in making men aware 
of what it was doing to them! 

Yet the substitution of machine for hand labor meant nothing 
legs than the introduction of a new species of creature, which 
rapidly became the dominant personality in industry, especially 
in the actual physical work of manufacture and transportation. 
Formerly the laborer was the central figure; he worked according 
to the laws of his being and his tools worked as he required their 
services. Now the machine is the central figure, and labor 
follows the laws of the machine’s being and works as it requires 
his services.^ 

6. MACHINE VERSUS MAN: HOW THEIR COSTS BEHAVE 

Perhaps the fundamental trait of the human laborer is an 
elastic sort of stability without complete uniformity. He 
builds on a foundation of habit and custom, yet he seldom or 
never does things twice exactly alike. He has many and varied 
capacities, demanding varied activities to develop him into 
a healthy being and keep him so. He turns naturally from one 
thing to another; therefore when he does one thing he sacrifices 

1 Letters on the Factory Act (London, 1837), pp. 11-13. Cited by Marx in the 
same passage as the former quotations. 




8 


ECONOMICS OF OVERHEAD COSTS 


something else he might be doing. This fact underlies the cost 
of any one kind of work, or the cost of work in general, as over 
against leisure and the pursuits and enjoyments which it makes 
possible. Having learned one way of doing a thing the human 
worker tries variants on it, sometimes with a purpose and some¬ 
times aimlessly, but always following the bent of “ monkeying, ” 
which has put him where he is, at the head of the animal kingdom 
and has given him his godlike powers of knowing and transform¬ 
ing the world in which he lives. He is very imperfectly adapted 
to continuous toil and when he does work he works, now faster and 
now slower, with an irregular rhythm of which he is himself often 
unconscious, but which characterizes all organic nature. Espe¬ 
cially when working for a purely collective end, his ardors, while 
often strong, appear to be characteristically intermittent and 
unreliable. As a class, he needs personal incentives to work— 
rewards for good performance and penalties for bad—more imme¬ 
diate and substantial than his share in the welfare of the whole 
industry or the whole community. In many cases, he seems 
to need the fear of losing his job to make him do his best. And he 
is, under our social system, a free being, responsible for his own 
continuous support and that of his family; hence his maintenance 
is his own burden and not an obligation of industry, except so 
far as he can exact wages that will cover it. 

Contrast with this picture that of the machine. A mere 
piece of property, incapable of maintaining itself; its maintenance 
falls, therefore, on its owner, as a “ constant cost.” Its work is 
not affected for better or for worse by the compensation paid 
for it: it does not need the incentive of a piece-wage system nor 
the fear of discharge to make its wheels grind with their utmost 
power and speed. It needs no incentives—only maintenance. 
Because of this moral superiority the person who furnishes the 
funds to buy the machine can get his reward as a guaranteed 
stipend or as a share in the collective earnings of the enterprise, 
and the machine will do just as good work as under any other 
system of payment. Yet if this were done to labor, at least in 
its present stage of development, all but the best laborers would 
be more or less demoralized and discipline and output would suffer. 



GRADUAL DISCOVERY OF OVERHEAD COSTS 


9 


This mechanical slave has absolutely none of labor’s thirst 
for variety. Uniformity is his passion; continuous operation 
his religion. He is tireless: his capacity limited only by the 
hours of the day. And if any of it is not used it is lost: he 
cannot fill his idle time with side-occupations. Viewed as an 
animal he is one whose instinctive inheritance prescribes every 
act of his life. Minor changes in patterns of behavior require a 
surgical operation; major ones require that he be born again. 
Hence he yearns to specialize and to turn out indefinitely large 
quantities of his specialty. 

^For all these reasons the machine’s costs behave differently 
from those of labor and follow different laws. In the first place, 
they are “overhead costs” in a much more definite sense and in 
a much more visible way. Secondly—and this is more important 
—they fall on industry as constant charges instead of being 
translated into a variable charge proportioned to services rend¬ 
ered: a system which would leave the individual investor to 
bear his ultimate burdens in the same way in which the laborer 
now bears his. 

\ 

7. OVERHEAD COSTS ON RAILROADS 

However, this fact did not have its full effect until the largest 
mechanical unit of all—the railroad—had reached maturity 
and had had its transforming effect on industry, making possible 
the fullest development of mechanical production in other lines 
by enabling the output of mammoth plants to find a market. 
There resulted the struggle for world-markets, cut-throat compe¬ 
tition, discrimination, the modern forms of the business cycle, 
and the growth of monopoly. But it was the railroad itself that 
first brought the notion of overhead costs into real prominence 
with economists. When railroads were new, their rates were 
commonly uniform or nearly so, based on weight and distance, 
and were uniformly high. Soon it was discovered that additional 
traffic could be carried at little or no additional cost and that 
reduced rates, if confined to classes of traffic not already moving, 
would increase the net earnings of the company. Thus classi¬ 
fication was born and the foundations were laid for cheaper 


IO 


ECONOMICS OF OVERHEAD COSTS 


railroad carriage than would ever have been possible without 
discrimination. 

Along with it or after it, however, came many other less 
innocuous types of discrimination, often without rhyme or reason, 
and harmful even to the roads that used them. Rate wars and 
receiverships followed. Shippers at local points saw goods 
hauled past them to junctions beyond at lower rates than they 
paid for their shorter hauls, and with simple logic reasoned that 
if the lower through rate was adequate, the higher local rate 
was obviously extortionate. Under pressure of contending 
interests, with the need of justifying practices against attack, 
the theory underlying discrimination became vocal and explicit, 
and the world learned that railroads were different from other 
industries because such a large part of their costs were “con¬ 
stant” or independent of traffic. 

Thus the world of economic thought was made aware of a 
fact which is older than railroads, older than economic science 
and, far from being a peculiarity of one business or of a group 
of highly capitalistic businesses, is universal. From the present 
point of view, the thing that seems more in need of explanation 
is why economists should have thought that other industries 
were different from railroads or why they should have thought 
that they had explained the prices of single goods by showing 
that they tended, under competition, to cover the expenses 
of production. 

So far as railroads were concerned, the chief use made of the 
notion of overhead costs was to justify discrimination as a general 
practice, on the ground that added traffic was not responsible 
for those costs which did not increase as traffic increased, and 
that in any case it was impossible to determine the proper share 
of costs traceable to one shipment or one unit of business . 1 
Some attempts were made to estimate in figures the relation 
between traffic and cost; the question being framed in the form: 
“What percentage of railroad expenses are constant and what 
percentage variable?” The common conclusion was that about 

1 On the other hand, as early as 1850 Dionysius Lardner, in his Railway Econ¬ 
omy, worked out an elaborate system of allocating overhead costs. 


GRADUAL DISCOVERY OF OVERHEAD COSTS 


II 


half the operating expenses were variable and everything else, 
including taxes and all return on capital, was constant . 1 As 
for the fact that increased traffic demanded increased investment 
of capital in equipment of all sorts, this was recognized in varying 
degree by different writers, but was never thoroughly harmon¬ 
ized with the formula of constant and variable cost. The upshot 
was that the makers of rates were assumed to know their own 
interests, and while it was clear that no one in or out of the 
railroad business knew the “variable cost” of any given class 
of traffic, it was assumed that the facts of cost justified wide 
discriminations, and the practice of “charging what the traffic 
will bear” was given the benefit of the doubt so far as cost was 
concerned. The question of distinguishing fair from unfair 
discrimination was left to be argued on other grounds. 

8 . OVERHEAD COSTS IN OTHER INDUSTRIES 

It soon became evident that railroads were not the only 
industry using large fixed capital and subject to the “peculiari¬ 
ties” of constant and variable costs. It also became evident 
that discrimination was not the only untoward result of such a 
condition. Rate wars on the railroads often abolished the regular 
classifications and brought all rates to a level far below cost. 
Large companies, railroad and industrial, failed, were reorganized, 
and continued in business, often more formidable competitors 
than before. It became evident that economic law did not insure 
prices that would yield “normal” returns on invested capital, 
because the capital could not get out if it wanted to, and so had 
to take whatever it could get. The business cycle had become a 
recognized part of the order of things, with its recurring periods 
of excess producing capacity, during which active competition 
tended to lower prices until even efficient concerns could make 
little or no return on their investment. “Cut-throat competi¬ 
tion” was seen to be a natural thing, and it was seen to be equally 
natural that business should adopt protective measures, whether 
combinations, pools, gentlemen’s agreements, or a mere senti¬ 
ment against “spoiling the market .” 2 

1 Cf. Ripley, Railroads: Rates and Regulation (1921), chap. ii. 

2 Alfred Marshall, Principles of Economics (6th ed.), p. 375. 



12 


ECONOMICS OF OVERHEAD COSTS 


9. hadley’s summary of the problem 

A. T. Hadley expressed these tendencies with remarkable 
compactness in the following passage: 

The investment of fixed capital described in the preceding chapter has 
wrought much more radical changes in manufactures and transportation than 
in agriculture. 

Each producer can extend his output with a gain rather than a loss in 
economy. If he can increase his sales, there will be only a slight increase— 
perhaps none at all—in the expense for wages and materials, and a decided 
decrease in the share of the charges on fixed capital which each unit of 
product must pay. There is no fixed standard of cost which we can treat 
as the normal price; for the cost per unit of product depends on the quantity 
sold, falling as sales increase. 

, The price which will induce new competitors to enter the field is also 
much higher than that which will lead old ones to withdraw. No concern 
will quit competition as long as it can pay an appreciable part of its interest 
charges. It is better to lose part of your interest on every piece of goods 
you sell than to lose the whole of it on every piece you do not sell. As long 
as the price received more than covers the expense for wages and materials, 
each of the old factories will continue to compete. Even if it changes 
ownership by foreclosure it will remain in operation. But, on the other 
hand, no new competitor will be called into being unless the price is high 
enough to afford a liberal profit, after paying interest, maintenance, and 
other charges on fixed capital invested under modern methods. Thus 
prices, instead of constantly tending to gravitate toward an equitable 
figure, oscillate between two extremes. The rate of production, at figures 
which give a fair profit, is usually either much larger than the rate of con¬ 
sumption, or much smaller. In the former case, prices are unremunerative 
and unjust to the producer; in the latter case, they are oppressive to the 
consumer. The average price resulting from such fluctuations may per¬ 
haps be a fair one; but the wide changes of price are disastrous to all parties 
concerned. 

.... In some cases the industrial units which are necessary for proper 
utilization of labor have become so large as to produce actual monopoly. 
. . . . Even in cases where the necessity for concentrated management is 
not quite so marked, .... the competition of different concerns always 
involves a loss, from the need of maintaining too many selling agencies, 
the expense of unnecessary advertising, and the lack of proper utilization of 
fixed capital . 1 

Here we have an array of problems, primarily relating to the 
economist’s search for the laws governing normal and market 

1 A. T. Hadley, Economics (1896), pp. 151-54. 



GRADUAL DISCOVERY OF OVERHEAD COSTS 


13 


price and to the question whether competition is natural and 
can endure. If monopoly is natural and if competitive price 4 
tends to no definite level, much of one’s old economics needs 
revising. The “cost of production to the marginal producer” 
no longer governs value, for the most expensive production is 
practically always being carried on at a loss. 1 And if the 
“marginal cost” of production means the additional cost of 
additional output in a plant working at part capacity, it does 
not cover return on investment and may not cover all of operat¬ 
ing expenses. The idea that price is governed by marginal 
cost of production may be reduced to.a tautology; the marginal 
producer is the producer whose cost of production is equal to 
the normal price. 

Alfred Marshall avoided a barren tautology by making his 
theory hinge on the expenses of production of a “representative 
firm” which has gained the chief economies of large-scale pro¬ 
duction. 2 J. B. Clark considered that the force of competition 
was continually driving prices toward the cost of production of 
the most efficient concern, at a speed governed by the rapidity 
with which its processes could be imitated or its own plant could 
expand, 3 though he also noted the importance of the variable 
costs of inefficient producers. 4 The goal would never be reached 
because it was itself in motion. Still more recently, during the 
world-war, the statistics of costs gathered to guide the work of 
regulating prices yielded the idea of “bulk-line” cost, so selected 
that the bulk of representative producers are below it and only a 
sporadic 10 or 15 per cent are above it. These last may be 
chronically inefficient, or may have had accidents which render 
the year in question a peculiarly bad one for them. The figures 
gathered in the war years do not necessarily represent the law of 
competitive price in undisturbed times but they represent a type 

1 “Cost” is here understood to include interest on all capital invested, in har¬ 
mony with the usage of the economic theory we are discussing. The various 
possible meanings of cost will be examined in chap. hi. 

2 Marshall, op. cit., esp. p. 343. 

3 J. B. Clark, Essentials of Economic Theory , pp. 286-87, and chap, xxi, esp. 
p. 369. 

4 Ibid ., p. 288. 


14 


ECONOMICS OF OVERHEAD COSTS 


of study which may give the law a definiteness that is much 
needed, especially since it became evident that production can 
continue indefinitely even though “overhead costs” are not 
covered. 


IO. THE CONTRIBUTION OF COST ACCOUNTING 

In the meantime business has developed the technique of cost 
accounting, including methods of allocating costs which cannot 
be directly traced to given units of product. This may be con¬ 
fined to seeing that all products are charged with a share of all 
operating expenses, or it may also include a share of interest on 
investment. This obviously offers great possibilities in the way 
of developing a standard of sound or conservative practice in 
fixing prices, which will act as a check on cut-throat competition. 
It also offers great opportunities for the development of arbitrary 
and fictitious notions of cost, through the necessity of apportion¬ 
ing items somehow, even if there is no satisfactorily scientific 
basis on which to do it. And of course the critical point is, 
after all, what the management does with the figures after it 
gets them; what use it makes of them in the actual fixing of 
prices. Cost accounting is still in a formative stage, though 
it has already developed a voluminous literature, and its vocabu¬ 
lary gives it at least one of the characteristics of science—that 
of being inscrutable to the uninitiated. Perhaps the most 
promising sign of development is the beginnings of true statistical 
method in the use of cost-accounting data. 

II. DEVELOPMENTS IN PUBLIC UTILITIES 

Other important developments have occurred in connection 
with public utilities, especially, perhaps, the business of furnishing 
electric current. Here, for the first time, organized technical 
attention is paid to the recurrent ebb and flow of output and the 
daily and seasonal “peaks” of demand. The sagging of demand 
at off-peak hours represents waste in the form of unused pro¬ 
ductive capacity, or “idle overhead.” The interest on the 
capital investment is mostly independent of output actually 
produced, and is governed by the output the plant stands ready 
to produce. This is a cost, then, which off-peak business need 


GRADUAL DISCOVERY OF OVERHEAD COSTS 


15 


not pay in order to be worth taking. The problem of policy 
involved is twofold—to stimulate off-peak business in various 
ways and so improve the utilization of the plant, and to apportion 
justly the burdens that do not vary with output. Here again, 
as in the case of cost accounting, a body of technique has devel¬ 
oped, with a considerable literature and a special vocabulary. 

Here, for the first time, we find price policies based on overhead 
cost being worked out by definite mathematical formulas so that 
their differentiated rates lay claim to be scientific, not merely 
qualitatively, but quantitatively; and correct, not simply in the 
general character of the discriminating charges, but in amounts as 
well. This, and the recognition that fluctuations of output 
involve “idle overhead” in the shape of waste productive capac¬ 
ity, are the two big contributions of the public service industries 
to the general development of the economics of overhead costs. 
This idea of peak loads, and of waste through irregular utilization, 
has come to apply to practically every industry in some form or 
other. Restaurants, theaters, golf clubs, garment-making indus¬ 
tries, railroads and street cars, building, and other trades—all 
have their peaks, daily or seasonal. And all industries suffer 
in common from the unpredictable irregularities of the business 
cycle. 

12 . LABOR AS AN OVERHEAD COST 

Once the holding of unused productive capacity is conceived 
as “idle overhead,” it was inevitable that the idea should be 
extended to human powers as well as to the powers of physical 
plant and machinery. G. P. Watkins, in discussing the load 
factor (ratio of average output to maximum output) includes 
a discussion of the load factor of labor, indicating that the waste 
involved is as real as in the case of capital. 1 Wherever a laborer 
has invested time and money in specialized training, the result 
is, in a certain sense, fixed capital which is useful in one occupa¬ 
tion and in no other, and which must earn whatever return it 
can, because the investment cannot be withdrawn and moved 
into some other line of business. In such a case it seems fairly 
clear that labor involves an overhead cost. 

1 G. P. Watkins, “ A Third Factor in the Variation of Productivity,” American 
Economic Review , V (December, 1915b 753“86. 





i6 


ECONOMICS OF OVERHEAD COSTS 


In a more general sense, however, there is a minimum of 
maintenance of the laborer’s health and working capacity which 
must be borne by someone, whether the laborer works or not: 
that is, if it is not borne, if the maintenance is not forthcoming, 
the community suffers a loss through the deterioration of its 
working power which is at least equivalent to the cost of main¬ 
taining the laborer. Thus the burden is there in any case: it 
cannot be avoided. From this point of view it appears that a 
large part of the cost originally counted as wages represents an 
overhead cost which the laborer is responsible for covering as 
best he can, just as the employer is responsible for covering the 
overhead cost on account of capital. However, if the laborer 
fails to cover it the community does not escape the burden, and 
it is ultimately borne by industry in the shape of reduced pro¬ 
ductive power and damaged morale. And thus it comes back 
to the employer in any case. There are other features of the 
human cost of labor corresponding to some of the particular 
phases of overhead costs in connection with large fixed capital, 
but they may be reserved for more detailed treatment later. 

If this last step is taken, overhead costs are seen to be a 
universal fact. The reason why the expenses of production, 
some of them, normally vary in proportion to output is simply 
because the terms of the wage contract are drawn in that way. 
The employer leaves the wage-earner to care for his own over¬ 
head and the terms of the contract are not scientifically adjusted 
as, for instance, the contract for electric current is sometimes 
adjusted, to the overhead costs of the ultimate producer. It 
may be that we shall find that our general system of wage 
payment is thoroughly unscientific and that a more scientific 
system may operate to improve the steadiness of employment 
in much the same way in which scientific rate systems have been 
used to increase the regularity of use of electric power plants. 

The foregoing brief sketch of the development of the idea of 
overhead costs indicates that it is a thing of many different 
aspects. Before plunging into the mass of detail which these 
various aspects involve, it will be worth while to take a brief 
survey of the field and gain a general view of the range of prob¬ 
lems it contains. 


CHAPTER II 

THE SCOPE OF THE PROBLEM 

SUMMARY 

Value and cost the test whether business is economically self-sustaining, 17— 
Complications introduced by overhead costs, 19—Conservative versus radical 
views of depression, 19—Is labor an overhead cost to society? 20—When to 
count overhead costs and when not, 21—Different dimensions of business, 22— 
The paradox of overhead costs, 23—The business depression and cut-throat 
competition, 24—Size, specialization, and integration, 24—Shifting and con¬ 
version of overhead costs, 25—Private versus social accounting in time of depres¬ 
sions, 27—Insurance as a conversion of variable into overhead costs, 30—Is the 
argument dangerously radical ? 30—Problem of assessing and collecting overhead 
costs, 31—Principle of incentives modifies older ideas of fairness, 33—Con¬ 
clusion, 34. 

I. VALUE AND COST THE TEST WHETHER BUSINESS IS 
ECONOMICALLY SELF-SUSTAINING 

The backbone of the science of economics is the balancing 
of value against cost. This sets up a test by which to judge 
any activity—the producing of any goods or the rendering of 
any service—in order to prove if it be economically self-sustaining 
or no. Other activities may be worthy, charitable, public- 
spirited, even vitally necessary to the public welfare or the 
public safety, but they are not paying business and they are 
often thought of as a variety of poor relations; dependents which 
must, in one way or another, be supported by business which 
does pay. People are inclined to think of such things as not 
economic activities at all. They are often very nice things to 
have, but they are not part of the problem of Economic Efficiency. 

Economic efficiency consists of making things that are worth 
more than they cost, and it is the peculiar characteristic of private 
business, under a competitive system, to seize and exploit any 
opportunity to achieve this desirable end. Thereby—so runs 
the argument—it tends to produce as much of everything as 
can be produced without driving value below cost, and any 
more would not be economically worth producing. 


17 


i8 


ECONOMICS OF OVERHEAD COSTS 


P'or example, if people undertake to make more automobiles 
than other people will pay for, the automobile business will 
become unprofitable, and the surplus of labor and resources 
that were making automobiles will look for something else to do 
for which a demand can be found. Ultimately, after some pos¬ 
sible tribulations, they will find their way into house-building or 
the moving-picture business or something else for which there 
is an adequate demand. Thus they are placed where they can 
do the most good—economically speaking. If a business can¬ 
not make a profit, that is a sign that some of the resources it 
utilizes are not in the right place. 

This idea that production must cover its expenses in order to 
justify itself is also applied to times of business depression, when 
output is curtailed because it would involve a loss to keep the 
wheels moving at their regular speed. In this case it is diffi¬ 
cult to say that labor is thrown out of work because it is not in 
the right place and should have gone elsewhere, because virtu¬ 
ally all industries suffer from the same disease at the same time. 
For the present, at least, there is no “elsewhere” to go. 1 This 
being the case, the losses of producers cannot exactly serve as 
salutary penalties, to spur misjudged people into the right 
avenues of usefulness; they merely prevent things from being 
produced when there is no “adequate market” and the goods 
would not be worth what they would cost." 

But what is the cost of goods, under such circumstances? 
Not of goods in general but of particular additional supplies 
that might be produced if the market only permitted? What 
does it cost the railroads to haul a carload of lumber to 
market, or the half-idle car manufacturers to make a car to 
haul next year’s lumber, or the steel plants to make the steel 
to make the car, or the mines to mine the coal to make the 
coke to smelt the steel, or what would it cost the miner, sitting 
idle in front of his shack or filling in the time with incidental 

1 Since writing the above I note that it is borne out by Professor W. I. King’s 
analysis of employment in the depression of 1921. He finds that there is very 
little shifting from one employment to another. See Employment Hours atid 
Earnings in Prosperity and Depression , New York, National Bureau of Economic 
Research, 1923, esp. pp. 25-28. 


THE SCOPE OF THE PROBLEM 


19 


gardening, to go into the mine and get the coal out ? What is 
the cost of anything, at any time ? The instant we try to give 
a thoroughgoing answer to such a question we find ourselves 
perplexed by the existence of “overhead costs.” 

2 . COMPLICATIONS INTRODUCED BY OVERHEAD COSTS 

To put it briefly, the costs we can trace are only a part of 
the costs of the business as a whole, which it must somehow 
manage to cover. What now has become of our rule of economic 
efficiency ? Is the carload of lumber worth carrying if it covers 
all the cost that can be attributed to that single carload ? Or is 
it only worth carrying if the railroad as a whole is covering all 
its costs, and what are they? Shall we count the costs that 
would keep on even if the railroad shut down entirely? Evi¬ 
dently “cost” is an ambiguous term and the test by which we 
are accustomed to decide whether production is self-sustaining 
or not has lost its meaning and requires a thorough re¬ 
examination. 

3. CONSERVATIVE VS. RADICAL VIEWS OF DEPRESSION 

Such a re-examination throws a most interesting light on the 
timeworn dispute over the interpretation of what happens in 
time of business depression. One group says that at such times 
production cannot be carried on because it will not cover cost, 
and appears to acquiesce in this accounting, while regretting 
the obvious evils that result. The other group finds food for 
satire in people going without overcoats because too many over¬ 
coats have been made, or sleeping on park benches because of 
an “overproduction” of houses. They speak of makers of shoes, 
clothes, and other things who are suffering for lack of each other’s 
products and who could perfectly well enter the empty factories 
and make them for each other, but are prevented because the 
capitalist owner exacts his toll of exploitive profits. 

The issue is partly one of fact and partly one of interpreta¬ 
tion. The defender of things as they are points out that, even 
if the return on the capitalists’ investment be labeled “exploita¬ 
tion,” there is no set minimum of such exploitation that is always 


20 


ECONOMICS OF OVERHEAD COSTS 


protected in time of depression; and that in point of fact busi¬ 
nesses often operate without yielding any return on investment 
at all. This is relieved of the taint of charity by pointing out 
that return on investment is an “overhead cost” which goes on 
whether the business operates or not, so that the owners are no 
worse off if they operate and do not earn it than if they stand 
idle and do not earn it. 

This last argument, however, is a risky one to use, for the 
same thing could be said of many of the operating expenses as 
well as of the return on investment. If it is good economy to 
operate a business without any return on investment, because the 
return would be lost just the same if the business shut down, is 
it not also good economy to operate at less than no return on 
investment, if the deficit is no greater than the operating expenses 
that would go on even if the business suspended operation ? Is 
it not good social economy to produce at an absolute financial 
loss rather than not at all? Some businesses have doubtless 
done just this at such times, but it is common knowledge that 
managers do their best to maintain net earnings and that, what¬ 
ever they might do if it became a question of avoiding a complete 
shutdown, they begin submitting to moderate curtailment of 
production long before net earnings disappear. Thus it appears 
to be generally true that production is curtailed while its value 
is considerably more than the cost specifically traceable to it. 

4. IS LABOR AN OVERHEAD COST TO SOCIETY? 

So far, the facts seem in part to justify the socialist critic of 
the existing order. But there is more to the story. Suppose 
the product cannot be sold for enough to cover the price of the 
materials and an ordinary living wage for the labor. It can 
still be argued that even this minimum financial expense is an 
exaggerated measure of the social cost of producing goods when 
the alternative is to let some of our productive power go irrevocably 
to waste. Wages are supposed to measure the personal sacrifice 
of toil for the laborer, but in this case the wages paid represent 
no personal or social cost whatever. Putting idle labor to work 
involves no “cost” to the laborer, unless idleness has already 


THE SCOPE OF THE PROBLEM 


21 


ruined his character. The “personal sacrifice of labor” means 
something for some purposes, but in relation to this problem it 
is meaningless. Offer a man the same pay whether he works or 
not, and he may prefer to be idle, though most men would wish 
to do some useful thing. But industry does not offer this happy 
choice. Involuntary idleness and the hunt for a job is so much 
worse than any personal sacrifice of normal and healthy labor, 
that by comparison the labor is good and not an evil. 

It comes down to this, that any use of labor that is worth 
anything at all is worth that much more than nothing. In 
that respect the socialist view of business depressions is correct 
and any rebuttal that attempts to explain away this fact 
by the reckonings of financial expenses is a bit of economic 
sophistry. 



WHEN TO COUNT OVERHEAD COSTS AND WHEN NOT 


Should we, or should we not, count “overhead costs” in 
deciding whether a given thing is worth producing? There is 
no universal answer: no formula by which all cases can be 
settled in advance. However, in a general way the rule is: 
whenever a policy is being considered which will involve “over¬ 
head expenditures” that could otherwise be avoided, they are 
part of the cost of that policy; likewise, when we are comparing 
two policies, each of which involves its own overhead, each should 
have its own overhead charged against it; but whenever we 
are choosing between two policies under both of which the same 
overhead outlay will have to be met, that overhead outlay is 
not a part of the cost specifically traceable to either policy. 
For instance: in comparing waterways, railroads, and auto¬ 
mobile highways as methods of freight carriage, wherever it is a 
question of building more of one or the other, or spending money 
to enlarge the capacity of one or the other, or even of maintain¬ 
ing them rather than letting them go out of use, there is an over¬ 
head outlay involved and it is a mistake not to include it. The 
fact that highways charge no tolls to cover maintenance or 
interest on highway bonds, while railroads have to cover main¬ 
tenance and interest, and pay taxes besides—this raises a real 


22 


ECONOMICS OF OVERHEAD COSTS 


question of fairness and efficiency which is important, but 
beyond the scope of the present chapter. 

Moreover, in reckoning overhead on highways it is not 
altogether simple to say what it is due to. The strength and 
cost of a modern motor route are related to the loads it is designed 
to carry. These outlays are chiefly chargeable to the heaviest 
motor-truck traffic: that which actually requires the full 
strength which has been given to the foundation of the road, 
or still more, the overloaded trucks that exceed the capacity of 
the road and break it down prematurely. 

The motor-truck operator may economize his overhead by 
making one truck do the work of two, but his saving may be 
negligible compared to the cost he imposes on the community. 
The cost of a given road might not increase perceptibly with a 
io per cent increase in the number of three-ton trucks running 
over it, but it might leap upward if that same io per cent increase 
in traffic were handled without increasing the number of trucks, 
by making io per cent of them twice as heavy. This represents 
a very real waste, with which the highway authorities are begin¬ 
ning to grapple, but so far they do not have the traffic data 
necessary to an adequate knowledge of the facts. Railroads do 
not exhibit the same difficulty, because costs of haulage and of 
maintenance come out of the same budget, and strength of 
roadway and weight of rolling-stock are planned as parts of one 
program. 


6 . DIFFERENT DIMENSIONS OF BUSINESS 

A little study of this everyday instance will serve to show 
something more about overhead costs. Costs have more than 
one way of responding to increased business and business has 
more than one dimension. It is necessary to distinguish the 
cost of increasing the capacity of a highway; the cost of carrying 
more traffic which is within the capacity of the existing highway, 
and the cost of carrying a given traffic in different sizes of truck 
loads. In none of these cases will cost vary exactly with volume 
of business, except by accident; and in each case there will be 
a residuum of untraced cost, but it will not be the same residuum 



THE SCOPE OF THE PROBLEM 


23 


in the three cases. Evidently, when we undertake to study how 
cost varies with varying output, we must differentiate between 
one case and another, or our results will be wholly meaningless. 

7. THE PARADOX OF OVERHEAD COSTS 

When it comes to making use of the facts of overhead cost 
in the attempt to promote the fullest utilization of our equip¬ 
ment of productive resources, there arises the paradox of price. 
This runs as follows: if any business that would pay its own 
particular costs is refused because it will not pay its share of 
overhead, there is a loss. Yet prices must be charged which 
will cover the overhead, so long as industry depends on private 
enterprise. There is only one answer to this dilemma—dis¬ 
crimination. The overhead costs must be levied on such parts 
of the business as will stand the burden, while other parts of 
the business, which cannot otherwise be had at all, are charged 
whatever they can pay, regardless of overhead costs. However, 
this is only a partial answer to the question, and creates more 
problems than it solves. 

To keep discrimination from degenerating into sheer favorit¬ 
ism there should be some objective standards to follow. In many 
cases business divides itself naturally into classes which can be 
made the basis of differential charges without personal favorit¬ 
ism. In the case of joint products the practice may go no 
farther than fixing the prices, for example, of dressed beef, 
hides, and other by-products in such relation to each other that 
no parts of the steer will be wasted, and this can hardly be called 
discrimination at all. Or a special class may be made of busi¬ 
ness that comes at times when the plant is not fully occupied. 

The night rates on telegrams and long-distance telephone calls 
are examples of rates to develop this “off-peak” business. Or 
special rates may be made for large orders, long hauls, or other 
specially economical varieties of traffic, often involving the fact 
that there are some costs that are traceable to particular orders 
but do not vary with size of order, length of haul, etc. Even 
where rates are based upon such objective criteria they may still 
be unfair as between classes of business. Differences, real or 


24 


ECONOMICS OF OVERHEAD COSTS 


imaginary, in the quality of different grades of goods, may be 
used as pretexts for discrimination. Where this happens, or 
where a business discriminates without any pretext, obvious 
questions of unfairness arise. 

8. THE BUSINESS DEPRESSION AND CUT-THROAT 

COMPETITION 

The business depression presents a case of “off-peak” busi¬ 
ness which is harder to deal with, partly because it is not pre¬ 
dictable and partly because it lasts so long that there are divi¬ 
dends to be earned by this off-peak business, so that if the 
off-peak business does not cover overhead expenses, they may 
* not be covered at all, and the result will be a general state of 
cut-throat competition. 

This is another of the characteristic results of overhead costs, 
and it presents a whole array of problems in itself. Fear of 
such competition may deter possible competitors from entering 
a business and spur those already in it to form a monopoly, or 
to come as near it as law and public opinion will permit. And 
without formal combination, tacit understandings arise and a 
sentiment is cultivated which regards cut-throat competition as 
contrary to business ethics. Among other things the growing 
technique of cost accounting plays an appreciable part in giving 
definiteness to the line between proper and undue cutting of 
prices. 

9. SIZE, SPECIALIZATION, AND INTEGRATION 

Another question involved in this general field of study is 
the economical size and type of the business unit. Large-scale 
production affords an opportunity for making more effective 
use of many services and facilities whose cost is of the “over¬ 
head” type. Sometimes, however, this result can be still more 
effectively secured if these services or facilities secede and 
become the basis of a separate enterprise, whose customers 
would include the original enterprise and all its competitors and 
perhaps many enterprises in quite different lines of business. 

Thus the work of advertising has become specialized, and has 
reached an efficiency which sheer growth of large-scale concerns 


THE SCOPE OF THE PROBLEM 


25 


could never have produced so long as advertising was a mere 
department of a manufacturing business. This sort of specializa¬ 
tion does, however, involve one more process of negotiation and 
exchange. The advertising concern must advertise and sell its 
own services and this involves costs, which also must be classed 
as “overhead.” Sometimes these outweigh the advantages of 
specialization, and then efficiency demands integration. What 
actually goes on is a continual experimenting with different 
groupings of functions, constantly testing which of these econo¬ 
mies of overhead cost counts for the most in a given case and 
at a given time. Some of these specialized functions, especially 
in the general field of research, can be taken over by co-operative 
organizations or by government itself. 

Standardization is another phase of this general process. - 
It means reducing the number of models or sizes and turning 
out more of each, with a saving in those overhead costs which 
each separate size or model involves. On the other hand, a 
selling force can often handle a fair variety of goods more effec¬ 
tively than a “line” that is too narrowly specialized. There is 
a considerable element of “overhead cost” in the work of buying 
and selling. 

IO. SHIFTING AND CONVERSION OF OVERHEAD COSTS 

Another subject which presents very real difficulties is that 
of the discrepancies between the overhead costs of businesses 
taken separately and those of the industrial system as a whole, 
or the ultimate personal sacrifices on which the whole structure 
of financial expenses rests. Some of these discrepancies have 
already appeared in connection with business depressions. The 
root of many of them lies in the shifting and conversion of over¬ 
head costs as they are passed on from the person who incurs 
them to his customers. In this process constant costs may be 
converted into variable, or variable into constant, though the 
latter change occurs far less often. 

For example, the costs of a telephone company are partly 
constant and partly variable, while the charge to the consumer 
may be wholly constant (so much per month regardless of 


26 


ECONOMICS OF OVERHEAD COSTS 


number of calls) or wholly variable (so much per call with 
no reduction for quantity). Or the charge may be a mixed 
one, corresponding more nearly to the way in which the com¬ 
pany’s expenses behave. If the charge is constant the user 
gets added service for nothing although it costs the company 
something to render it, and there is danger of wasteful use. If 
the charge is so much per call, then added calls cost the user 
mpre than they cost the company, and there is danger of waste¬ 
ful non-use through shutting off some telephone calls that would 
be worth more than their special cost but less than the rate 
charged. Wherever constant costs are converted into variable 
or variable into constant, there is a stimulus either to wasteful 
overuse or wasteful disuse of our productive facilities. 

Most of the ultimate sacrifices of production have something 
of the “overhead” quality about them. We have seen that 
even the time of the laborer does not always involve a sacrifice 
that could be charged at so much per day without misreporting 
the facts of the human economy. However, when a laborer 
does sell his services for so much per day, his employer naturally 
charges the expense against the value of the day’s work. So the 
cost of labor becomes a “variable expense” by virtue of the wage 
contract, regardless of what may be the ultimate facts of human 
cost. In the same way the whole price of materials used is a 
direct expense, regardless of how much of it may represent over¬ 
head costs to the maker of the materials. 

One of the stock examples of overhead cost is the cost of 
using machinery; maintenance, depreciation, and return on 
investment; but this may become a direct and variable cost to 
the user of the machinery if he leases it from the owner and pays 
according to use. Thus the United Shoe Machinery Company, 
a large and strong concern, took on itself the overhead costs 
of smaller shoe manufacturers by leasing its machinery to them 
instead of selling it, thus converting the cost of capital into a 
variable expense to the shoe manufacturer. The wage worker 
in a similar way assumes responsibility for his overhead burdens, 
the chief difference being that he lacks the financial strength of 
the United Shoe Machinery Company, and cannot bear the 


THE SCOPE OF THE PROBLEM 27 

burden successfully. Evidently the question how much over¬ 
head cost there is in any particular industry depends largely or 
entirely on the system of contracts under which industries acquire 
the use of the factors of production. The wage system makes 
labor a direct and variable cost and the system whereby corpora¬ 
tions own their own fixed capital makes that an overhead cost. 
There are reasons for this system; natural reasons and historical 
reasons, but it would be quite possible to draw contracts in 
such a way that labor would be the overhead expense to the 
employer and machinery the direct and variable expense. In 
either case, however, the nature of the ultimate sacrifice would be 
the same. When it is a choice between use and involuntary 
idleness, the bulk of the ultimate costs of industry are “over¬ 
head costs.”1 


II. PRIVATE VERSUS SOCIAL ACCOUNTING IN 
TIME OF DEPRESSIONS 

The implications of this proposition are so interesting that 
it may be worth while to pause in our survey and look at it more 
closely. If ultimate costs are nearly all overhead it follows that 
it would pay for industry as a whole to keep going rather than 
stand idle, even if the product were worth next to nothing. And 
yet any serious drop in prices is the signal for widespread slack¬ 
ening of production. Industry as a whole is unwilling to treat 
its expenses as overhead and act accordingly. 

Single enterprises are often willing to disregard their over¬ 
head costs in a time of slack demand, though many are always 
too much afraid of “spoiling the market.” But it is not enough 
for any one enterprise to do this, nor for all the enterprises in 
any one stage of an industry to do it. The producers of every¬ 
thing they buy would have to do it at the same time, and again 
the producers of everything that these producers buy, and so on 
indefinitely, back to the ultimate raw material and forward 
through every metamorphosis or handling until the goods reach 
the ultimate consumer. Retailers would have to force on the 
market goods they had bought when prices were up. Hardest 
of all, labor would have to do the same thing; that is, be ready 




28 


ECONOMICS OF OVERHEAD COSTS 


to sell its services for whatever they would bring and make up 
its necessary maintenance—if at all—out of the earnings of 
better times. 

If all acted at once, each one would feel the stimulus to 
demand resulting from all the price concessions taken together, 
and it would be very great in proportion to the sacrifice required 
of each single producer. As it is, each acts by himself and, for 
the moment, feels only the stimulating effect on demand resulting 
from the concessions he has made in his own limited field. 
Perhaps his own personal toll (the margin over which he has 
control) represents 2 per cent of the ultimate selling price of 
the goods; perhaps 4 or 10. Only in rare cases would it be as 
much as 20. He may cut his toll in two, then, without effecting 
more than from 1 to 10 per cent reduction in the final price of 
the goods. Here the stimulating effect on demand will be very 
small in proportion to the sacrifice required. Moreover, labor 
is in no position to make slashing reductions in its wage demands 
and live on accumulated savings. Thus it is the part of indi¬ 
vidual financial wisdom or necessity to protect one’s margins 
and let demand fall off rather than see the margin of net income 
approach the vanishing point. 

This statement does not take account of the possibility of 
one producer increasing his own sales at the expense of his 
competitors, so that he is not dependent on increasing the total 
demand for an increase in his own volume of business. A slight 
cut in prices might increase his sales hugely (if his competitors 
did not follow suit). In short, we have ignored the typical 
tactics of active competition. This omission is largely justified 
by the fact that genuinely unrestrained competition has, under 
such conditions, proved so disastrous to the competitors that it 
has developed its own antidotes in the shape of a sentiment 
against cut-throat competition and the “spoiling of the market.” 
The actual result, then, is a compromise between actual competi¬ 
tion and a spirit of mutual restraint which is essentially anti¬ 
competitive in character. 

One might contend that there is a conflict here between 
private and social interest which arises out of the essential nature 


THE SCOPE OF THE PROBLEM 


29 


of private enterprise; in that the social interest requires capacity 
output at any price as long as it is worth the excess cost of work¬ 
ing rather than standing idle, while private interest demands 
maximum net income above the “variable” costs of operation 
and strikes a balance between decreased output and decreased 
margin of earnings. The social interest appears to be on the 
side of cut-throat competition, which is much the same as inviting 
competitive business to commit hara-kiri. 

However, there is one saving fact. If everybody stood ready 
to cut down to the absolute minimum of “variable cost,” and 
if everybody shared such cuts as were made, nobody wauld have 
to cut that low or anything near it, in order to restore demand to 
a reasonably normal level. For the chief cause of falling-off in 
demand lies in the fact that any unemployment reduces people’s 
purchasing power and so returns on itself in a vicious circle 
creating more unemployment. If everyone were determined to 
sacrifice earnings whenever necessary to maintain output, this 
vicious circle would be broken and the chief cause of shrinkage 
of demand would disappear. Some primary causes of fluctuat¬ 
ing demand would remain, but their cumulative effects would 
be controlled or eliminated. 

Even the knowledge that such a policy could be confidently 
expected would tend to cure people of expecting depression and, 
because they expect it, curtailing purchases more violently than 
sales have actually been curtailed, and so doing their utmost to 
bring on the thing they expect. This phase of the question is 
quite like the philosophy of bank reserves. Under the old 
National Banking Act, a fixed percentage of reserves to deposits 
was required. If it was not maintained, new loans could not 
be made, and the banks actually suspended cash payments to 
protect their reserves, though the maintenance of cash payments 
was the only thing the reserves were good for—the only thing 
that made them worth keeping. All of which irresistibly sug¬ 
gests a man on a rock, jumping into the water for fear the 
tide will rise and wet him. 

If all the banks in October, 1907, for instance, could have 
announced that the time had come to use the reserves for the 








30 


ECONOMICS OF OVERHEAD COSTS 


purpose for which they had been accumulated, and that they 
would disregard legal requirements as to loans and not suspend 
cash payments till their vaults were empty of cash, there would 
have been no suspension and probably no serious strain on the 
parity between gold and deposits. Similarly, if everyone stood 
ready to cut prices to the limit to prevent unemployment, no 
one would have to cut very far. However, it requires more than 
intelligence and good-will on the part of single competitive 
banks to make the bank reserves actually available, and it will 
require something more to make available the reserves of pro¬ 
ductive power that go to waste in times of depression. It will 
require some means of common and co-ordinated action not less 
far-reaching and effective in the industrial field than the Federal 
Reserve System is in the banking field. And all to overcome 
evils traceable to the shifting of overhead and their conversion 
into direct costs in the process! 

12. INSURANCE AS A CONVERSION OF VARIABLE INTO 

OVERHEAD COSTS 

Insurance of property is another device whereby costs that 
vary (though they do not vary uniformly with output) are con¬ 
verted into constant costs. In this case the producer hires the 
insurance company to take them off his hands in exchange for 
a constant payment. Here the actual cost varies largely with 
the owner’s vigilance and there is danger of waste through unduly 
relaxing that vigilance, if not through actual fraud. 

13. IS THE ARGUMENT DANGEROUSLY RADICAL? 

When once the question is opened of discrepancies between 
social and business accounting, one cannot stop with costs alone 
but must at least recognize the existence of certain conflicts in 
standards of value. For example, are shoes worth less than 
usual in time of depression because the price is low or are they 
worth more than usual because people are not so well shod? 
An embarrassing question for an economist, perhaps, but one 
that must be faced in any serious study of the economics of the 
business cycle. 


THE SCOPE OF THE PROBLEM 


31 


^ Is the argument here presented becoming dangerously social¬ 
istic? That depends entirely on the reader’s preconceptions. 
It does no more than give some increased definiteness to a prop¬ 
osition which most persons would admit at once in the abstract: 
namely, that there are wastes and maladjustments in private 
industry which a socialistic organization would find opportunity 
to eliminate, if it could command sufficient intelligence to diag¬ 
nose the wastes correctly, and sufficient devotion, ability, and 
hard work to establish the collective type of efficiency without 
sacrificing the values embodied in the cruder, individualistic type 
we now have. This involves the devising of a system of social 
accounting that will work, and work better than our present 
system of financial accounting. 

The majority do not think the socialist organization could 
succeed in doing these things, while they do think the existing 
system can be made a more efficient engine for giving the com¬ 
munity what it or its members want. Indeed, the majority err 
on the side of too optimistic a faith in the perfectibility of the 
existing system, if only their pet measures are adopted. How¬ 
ever that may be, detailed analysis of discrepancies between 
social and commercial accounting, such as this study suggests, 
would be obviously of a great deal more use to a society that is 
trying to keep the system of private industry and amend its 
faults than to a system that throws it overboard and starts to 
build up its organization, and the accounting system that must 

• • "■'"I 

go with it, out of whole cloth. 

14. PROBLEM OF ASSESSING AND COLLECTING 

OVERHEAD COSTS 

But to return to the specific problems of overhead costs. 
Last, but not least, comes the problem of assessing, apportioning, 
and collecting them. Among the issues that hinge on this 
central problem, we have already mentioned the questions of 
discrimination, fair and unfair, cut-throat competition and 
restraints upon it, natural versus predatory monopoly, and the 
development of “off-peak” business, whether the peaks be daily, 
seasonal, or the irregular peaks of the business cycle. 


32 


ECONOMICS OF OVERHEAD COSTS 


The'problem involves the allocation of certain general burdens 
where reasonable men may differ as to what is a just apportion¬ 
ment. There is no natural system of prices in the old sense. 
Cost prices do not mean anything definite any more. Efficiency 
requires discrimination and discrimination has no universally 
accepted standard to go by to keep it from degenerating into 
favoritism. The epigram attributed to Lord Fisher, “Fav¬ 
oritism is the secret of efficiency,” takes on a new and far- 
reaching meaning. 

" There are four logical bases on which overhead costs may be 
apportioned. These are: (i) Ability to pay. This puts them in 
a class with taxes, which represent the levying of governmental 
overhead costs. (2) Causal responsibility. This is a somewhat 
elastic term, and the line of development is toward broader 
notions of what responsibility includes. (3) Benefit or use. 
This has something to do with ability to pay, and something to 
do with responsibility. (4) Stimulus to improved utilization. 
That is, anyone who has an opportunity to do anything to reduce 
society’s “idle overhead” may conceivably be moved to do so 
if a properly differentiated burden is laid upon him, with a chance 
to lighten the burden by doing what he can to improve the collec¬ 
tive efficiency. Such cases will ordinarily fall under (1), (2), 
or (3) also. These four principles do overlap in fact, more 
or less. 

For example, the proposal to make the cost of labor in part at 
least an overhead charge on the employer could be argued on 
all four grounds, the most decisive question being: Who can take 
the most effective action to eliminate idleness ? And the answer 
is that the laborer himself, the employer, and government are 
all so important that neither should be left without an effective 
incentive to do what can be done, but that the powers and 
opportunities of employers are probably greatest of the three. 
The fixing of prices, and wages, becomes in the last analysis a 
matter of placing these burdens in such fashion that they shall 
furnish the most effective stimulus to the full development and 
utilization of the productive powers of the nation. It involves 
saying that the overhead costs of labor may be laid upon the 


THE SCOPE OF THE PROBLEM 


33 


laborer, or upon the public, or upon the employer as the repre¬ 
sentative of the industry, in proportion to their responsibility 
for imperfect utilization or to their opportunty to improve the 
existing conditions. 

15. PRINCIPLE OF INCENTIVES MODIFIES OLDER IDEAS 

OF FAIRNESS 

Such a distribution of burdens may not be in harmony with 
our traditional ideas of payment or of liability, any more than 
the modern notion of employers’ liability for accidents or of 
compulsory insurance is in harmony with individualistic ideas 
of justice. The nineteenth century was accustomed to think 
it just that anyone should bear the burdens that fall upon him 
as a natural result of the contracts he has made of his own free 
will. This principle did not cover contracts made under duress, 
contracts made by parties incompetent to bargain, or contracts 
whose effect was to destroy or unduly limit one’s liberty for the 
future. Laws against harmful drugs and dangerous food prod¬ 
ucts, or police regulations covering such everyday practices as 
the inspection of milk and meat, involve a further limitation on 
the principle of free contract—the individual is to be protected 
from mistakes that might do permanent and serious injury to 
his health and so would cripple his real freedom for the future 
even though his technical legal freedom might remain unimpaired. 
Thus the principle of the justice of free contract has never been 
held without important qualifications. Under it, however, the 
laborer bore the burden of industrial accidents, industrial 
diseases, and unemployment—all of them ills of industry as a 
whole, and all of them due to causes over which the individual 
sufferer had no adequate control to remove or to minimize them. 

With regard to industrial accidents a different idea has already 
made its way into general acceptance. Accidents are regarded 
as costs of industry, to be borne by industry to the extent of 
reasonable compensation, and to make this right of compensa¬ 
tion effective the wage-earner must not be allowed to waive it 
by contract. This system has worked well in two ways. It has 
lightened the burden of accidents by distributing the loss that 


34 


ECONOMICS OF OVERHEAD COSTS 


used to fall with ruinous weight on a few. And it has created 
an effective financial incentive to accident prevention, roughly 
corresponding to the interest the community has in such work 
of human conservation, and it has placed that incentive where it 
could do the most good, on the person whose care or neglect 
can make the most difference to the number of industrial 
accidents: that is, on the employer. 

Of course, the workers are themselves jointly responsible, on 
account of the recklessness and unwillingness to use safety 
devices which characterize a part of them, and often endanger 
their more cautious fellows. These are well-known obstacles to 
employers’ efforts to promote safety in industry. But even from 
this point of view the education of the worker is best promoted 
by giving the employer a strong money motive which may save 
him from becoming too easily wearied of well-doing in this 
direction. Largely as a result of this new policy, the rate of 
industrial accidents has been reduced radically in the past twenty 
years, and an incalculable human and economic gain has resulted. 

During the same period the electric light and power companies 
have enormously reduced their “idle overhead” by improving 
their “load-factor,” bringing average output much nearer maxi¬ 
mum and thereby securing a great increase in efficiency. How¬ 
ever, during the same period the wastes through unemployment 
have shown no such improvement. Good-will and a general 
sense of diffused responsibility have so far failed to produce 
adequate results. 

16. CONCLUSION 

There are a number of other problems connected with over¬ 
head cost, particularly that of the length of the working day and 
the status of the slow or inefficient worker. But this preliminary 
survey is already becoming too extended. The wide range and 
far-reaching character of the problem are sufficiently manifest, 
and we may turn to a more intensive and systematic study. 


CHAPTER III 


THE GENERAL IDEA OF COST AND DIFFERENT 

CLASSES OF COSTS 

SUMMARY 

The different standpoints and purposes from which cost is viewed, 35— 
Absolute versus alternative costs, 37 —Direct observation versus differential 
analysis, 38 —Financial outlays of the company versus costs of producing goods, 
4 ° Long-run versus short-run fluctuations, 43 —Theoretical omniscience versus 
working approximations, 44 —Operating expenses and fixed charges, 46 —Differ¬ 
ential and residual cost, 49 —Variable and constant costs, first meaning, 51 — 
Variable and constant costs, second meaning, 53 —Other meanings of constant 
and variable costs, 53 —“Sunk” costs, 54 —Urgent and postponable costs, 55 — 
Direct and indirect expenses and kindred concepts, 56 —Joint ccst, 58 —Manu¬ 
facturing versus selling expense, 59 —Cost in the sense used by cost accountancy, 
64 —Is interest a part of cost, 65 —Cost from the standpoint of different pur¬ 
poses, 67 —Conclusion, 69. 

PART I. POINTS OF VIEW AND METHODS OF 

MEASUREMENT 

I. THE DIFFERENT STANDPOINTS AND PURPOSES FROM 

WHICH COST IS VIEWED 

The general idea of cost covers a number of different meanings. 
Especially about the fact of overhead costs there has grown up 
a bewildering confusion of business and economic terms describ¬ 
ing different aspects of it in ways that are sometimes correct 
and sometimes misleading, and sometimes inconsistent and 
ambiguous. People speak of such symptoms as “ increasing 
returns,” ‘‘constant and variable expenses,” “direct and indirect 
costs,” “prime and supplementary costs” and “sunk costs,” 
while such terms as “fixed charges” and “general expenses” 
are used in various ways to describe parts of these costs. Back 
of this there lies a great deal of controversy as to whether certain 
items are properly costs at all. Most of this controversy will 
disappear if we carry our study far enough to recognize that there 
are different kinds of problems for which we need information 
about costs, and that the particular information we need differs 
from one problem to another. 


35 


3^ 


ECONOMICS OF OVERHEAD COSTS 


Perhaps the best way to facilitate this is to think of the differ¬ 
ent people who are concerned with the study of costs in one way or 
another. There are engineers, general accountants, cost account¬ 
ants, statisticians, and economists, all with different angles of 
approach and different purposes to serve. The engineer has to 
make estimates of cost of construction and operation for differ¬ 
ent sizes and types of productive equipment, either for a single 
operation or for an entire plant. He is largely responsible for 
selecting the equipment and method of production that will 
yield the greatest total efficiency, or at least he has to furnish 
the management with the data necessary to make such decisions. 

As for accounting, it has many uses, and appears to be in an 
interesting state of transition, in which the relation of the newer 
technique of cost accounting to the older general accounting 
procedure is not fully established. For lack of a better term, 
we may call this general accounting procedure “financial account¬ 
ing” to distinguish it from cost accounting, although the two 
must, for certain purposes, work together and must rest on the 
same primary records. Financial accountancy is primarily 
concerned with recording absolute income and outgo, noting 
every separate bit of either and adding them up into correct 
totals. It has two underlying and elementary purposes which 
are probably dominant. The recording of every transaction 
makes it harder to steal the funds of the concern, and the find¬ 
ing of correct totals tells how much income is available for 
dividends at the end of the fiscal period. This last problem, 
more than any other, appears to govern the forms and definitions 
of the general or financial accountant. 

On the other hand, the cost accountant has to furnish informa¬ 
tion to guide the management in a great variety of questions of 
policy. He is concerned with efficiency of production, and the 
management expects him to gauge the efficiency achieved and to 
locate inefficiency. He is also concerned with discovering the 
cost proportionately attributable to particular parts of the busi¬ 
ness in order to guide the management in its price policies and 
selling campaigns. He gives them information on the basis of 
which they may exercise their judgment as to what parts of the 


COST AND DIFFERENT CLASSES OF COSTS 


37 


business are most profitable and what parts are of little or no 
profit; how low they can afford to fix prices on a particular 
contract or a particular class of business, or how high they ought 
to fix them, or how much they can afford to pay for materials 
to fill particular orders, or to spend in a selling campaign in order 
to develop some particular class of business. 

Information about the costs of business may be obtained not 
only by accounting but by statistics. The statistician is com¬ 
monly interested in general questions affecting many businesses. 
He may try to discover how great the profits of a given business 
are on the average, and how much they differ from one enterprise 
to another. It is possible, however, to use statistics in studying 
a single business, in trying to find out how its costs really vary 
in response to changes in volume of output or to changes in other 
characteristics of the business. This sort of study is not highly 
developed, but it is capable of becoming a valuable aid and 
supplement to cost accounting. 

Finally, the economist has to do with costs. He is concerned 
chiefly with the effect of costs on prices under natural competitive 
conditions, or with estimating monopoly profits as an excess 
over the earnings that competition would normally bring, or 
with establishing a fair level of prices and earnings in public 
service industries. 

With all these different people dealing with costs for all 
these different purposes, it is the most natural thing in the world 
that they should discover a large variety of ideas about costs, 
some adapted to one purpose and some to another. It would 
be impossible and useless to try to adopt a fixed terminology 
in case it would tend to prevent any one of these people from 
using the particular ideas which he finds convenient and neces¬ 
sary. The chief thing to do is to understand clearly the different 
ideas and their relations to each other and especially to the 
particular purposes they serve. 

2 . ABSOLUTE VERSUS ALTERNATIVE COSTS 

Perhaps the most fundamental distinction is that between 
two general classes of ideas of cost; absolute costs and alternative 


38 


ECONOMICS OF OVERHEAD COSTS 


costs. Cost in an absolute sense records all diminution of assets. 
Cost in the alternative sense records the unfavorable side of any 
given decision which may be made, and always involves a compar¬ 
ison between the policy that was chosen and the policy that was 
rejected. For example, let us suppose that we want to know 
the absolute cost of operating a given business, including all 
money paid out for wages and materials and all actual deprecia¬ 
tion or deterioration in the plant itself. These are absolute 
costs involved in the operation of the business and the main¬ 
tenance of the investment, for the end of the year must find 
the capital as large as it was at the beginning, or else no dividends 
can be considered earned. Whether interest is a cost in this 
sense or not is a disputed point, about which we shall have some¬ 
thing to say later. On the other hand, when a business is under 
way as a going concern, it often has to decide whether or not to 
make a special price in order to secure a certain order, or whether 
to undertake a selling campaign in order to enlarge the output, 
or to make various other decisions involving an increase or a 
decrease in the volume of business. In such cases the manager 
needs to know not merely one cost but two: the cost that he will 
incur if he makes the special price and takes the added business, 
and also the cost that he will incur if he does not. Or rather, he 
needs to know everything bearing on the question how much 
the added business needs to be worth in order to make him richer 
for having taken it than he would have been if he had not taken 
it. For this purpose, interest on investment counts, whether 
one chooses to define it as a cost or not. On the other hand, 
since it is the difference which is the important thing, any items 
common to the two policies may be canceled, and it is not 
necessary to discover just how large they are, or even to settle 
possible controversies as to whether they are costs at all. 

3. DIRECT OBSERVATION VERSUS DIFFERENTIAL ANALYSIS 

There are different ways of tracing costs. We may walk 
through a plant and see what items of work a given man or a 
given machine are engaged at, and in this simple way we may 
trace the costs of labor or of a machine to that particular bit 


COST AND DIFFERENT CLASSES OF COSTS 


39 


of business. This is the kind of tracing that is thought of in 
connection with the expression “direct cost” or “special cost.” 

However, this kind of cost tracing is not the basis for price 
policies in industrial concerns, and it would not be a proper 
basis for price policies even if every item of cost could be traced 
in this way. The direct costs of particular bits of business vary 
very greatly as a result of accident, weather, or unavoidable 
irregularities and imperfections of the materials worked with, 
so that two pairs of shoes, or two suits of clothes, of identical 
pattern, or two carloads of identically similar freight moved over 
the same stretch of track, may have cost very different amounts. 
A price policy has to be based on typical conditions. A consumer 
has to be charged in proportion to the worth of what he gets, 
not to the accidental variations in what it costs the producer 
to turn out things of the same value. There would be no real 
purpose served by separating the costs of every item of output. 
All the manager needs to know is the separate cost of such classes 
of output as might be the object of special price policies. 

There is, however, another way of tracing costs which is 
fundamentally different from this. Instead of merely looking 
at the process and seeing on what work particular assets are 
being used, we may focus our attention on the effect of a change 
in output in increasing or diminishing the total expenses. If 
a person is familiar with the operation o* the business he may 
be able to imagine the effects of such a change with reasonable 
accuracy, but if he wishes to be scientific he had better observe 
a number of such changes and record the results and see what 
effect the changes of output have on cost. It is this kind of 
tracing of costs that people have in mind when they speak of 
“constant and variable expenses.” 

These two ways of tracing costs have something to do with 
each other, to this extent: if certain workmen spend their entire 
time on a certain class of work, it is a fair assumption that their 
wages will vary approximately in proportion to the amount of 
that kind of work that is done in the plant. This is not neces¬ 
sarily quite true, however, for if hours are short they may work 
faster and this will cheapen the product if they are working at 


40 


ECONOMICS OF OVERHEAD COSTS 


a time rate, and if they work overtime at overtime pay, the wage 
bill will go up out of proportion to the output. The direct 
method of tracing costs breaks down when it comes to excess 
pay for overtime, even under a system of piece wages. 1 

Of the two ideas, namely, cost visibly traceable to particular 
business and changes in cost resulting from changes in business, 
the latter is the more fundamental and important as a theoretical 
basis for tracing responsibility for costs, although it is also the 
more complex and the harder to discover and use as a working 
tool for allocation. It is more important for fairly obvious 
reasons. If a given bit of business covers all the additional 
costs resulting from taking it on, then the concern is not poorer 
for taking that business than they would have been if they had not 
taken it. If it covers anything more than this they are richer 
for having taken it than they would have been if they had not. 

On the other hand, it may cover “special costs” or “direct 
costs” and still the concern might be poorer for having taken it, 
because some of the other costs may have increased on account 
of this business. For instance, interest on capital investment 
is not classed as a direct cost, and yet it varies with variations in 
the business, although not necessarily in proportion. As a 
result, a cost accounting system which ignores interest is likely 
to cause some business to be taken at less than it really costs or at 
least to represent some business as being much more valuable 
than it really is. 2 

4. FINANCIAL OUTLAYS OF THE COMPANY VERSUS COSTS OF 

PRODUCING GOODS 

Interest on funded debt is classed as a “fixed charge” and it 
is often wrongly assumed that this means that it is a “constant 
cost” of production. Others insist that while interest is a 
financial charge on the company, it is not a cost of producing 
goods at all. The fact is that while there is a real difference 

1 This point will be discussed more fully in the section entitled “Direct and 
Indirect Costs.” 

a This matter will be gone into more fully in connection with “Fixed Charges” 
and “Is Interest a Cost?” (sections 7 and 17 below). 


COST AND DIFFERENT CLASSES OF COSTS 


41 


between financial charges and costs of production, there is also 
an intimate connection between them, since the financial charges 
are incurred in order to furnish the wherewithal for the outlays 
of production. Therefore the two move in close sympathy, but 
not always at just the same time. 

Moreover, interest as a financial charge varies, even though 
interest on bonds does not, but its variations are complex and 
hard to trace. However, they move in such close sympathy 
with the variations of capital used in the actual producing of 
goods, that the most practicable way to trace them is to forget 
about the financial charges (except for the purpose of finding a 
fair representative interest rate) and to follow the process of pro¬ 
duction instead. 

The distinction between financial charges and costs of pro¬ 
duction may seem a confusing one, yet it can be simply illustrated. 
Suppose a concern borrows $10,000 to put into materials. It 
buys the materials, holds them in the stockroom for some weeks 
and then uses them in filling an order. Which act constitutes 
the expense: the borrowing of the funds, the buying of the 
materials, or the using of them in the actual manufacture of the 
product ? 

On this matter the standard accounting practice indicates 
the correct principle. The business firm does not calculate the 
costs of a given month’s business on the basis of the amount 
spent in that month for materials, but rather on the basis of the 
amount of materials issued from the stockrooms for actual use 
during that period. In the same way a railroad does not report 
cost of coal actually purchased in a given month as a cost for 
the traffic of that month, but rather the cost of coal issued for 
use in the engines. 

When money is borrowed a cost is incurred, but it is not yet 
determined that it is a cost of producing goods: still less is it 
known to what goods this outlay will be devoted. The concern 
may borrow more than it needs for the moment, and lend the 
excess until the time comes for spending it, so that their interest 
outlay for production may not really include all the interest on 
their bonds or notes. When they spend the money for materials 


42 


ECONOMICS OF OVERHEAD COSTS 


it is virtually committed to production (though even then some 
of the materials may ultimately be sold instead of used) but still 
no one knows just what goods it will aid in producing. It is 
not until the materials are issued for use that they can be charged 
against a definite product. This principle covers all costs charge¬ 
able to these goods, including interest if the concern sees fit to 
charge it, but it may be that in some cases the amount at issue 
is not worth the cost of tracing it and that some simpler procedure 
would be better for the business, on grounds of economy rather 
than of accuracy. 

The raising of fixed capital involves a similar principle, except 
that after the money is spent for machinery, the interest goes 
on whether the equipment is busy or idle, so that the amount 
of actual use can be disregarded. Here interest as a cost of pro¬ 
ducing goods is incurred when the money is spent for machinery, 
rather than when it is borrowed. Therefore it is essentially con¬ 
trary to good cost accounting practice to treat interest as a con¬ 
stant cost merely because the charges on the bonds are fixed, 
because this looks at the wrong index of cost: namely, the raising 
of the funds instead of the expenditure of them. 1 

The thing that should be looked at is the behavior of the total 
amount invested in the actual process of production, in order 
to see how much it varies in response to changes in business. 
This gives the true “variable cost” on account of interest, and 
the excess of tota 1 interest charges above what can be allocated 
in this way may be treated as a “constant cost” or may even be 
disregarded as a cost of producing goods and treated as a question 
of finance rather than a question of production. Thus the “con¬ 
stant expense” for interest on capital may be greater or less 
than the amount of interest on bonded indebtedness. 

The item of interest varies in many ways. A railroad may 
increase its current borrowings, or it may reduce its temporary 
holdings of interest-bearing securities, or it may draw down its 
interest-bearing deposits, or it may simply keep on its line more 
cars belonging to other railroads, meanwhile paying a rental for 
their use. All of these involve real increases of the net interest 

1 See discussion of “Fixed Charges,” section 7 below. 


COST AND DIFFERENT CLASSES OF COSTS 


43 


charges of the road. If a company borrowed $1,000,000 for 
additional cars which they expected to need within the next 
three years, and only spent half of the money during the first 
year, they would be forced to put the other half out at interest 
so that it would not be a great loss to them, and meanwhile 
the traffic would be properly chargeable only with the interest 
on the amount actually spent. The bonds might cost five per 
cent and the market might yield four and one-half per cent, in 
which case the difference is the cost of provision against future 
needs and of saving the trouble and expense of making two bond 
issues instead of one. Ordinarily, however, in such a case the 
road would arrange its bond issue so that it could be put out in 
instalments, and thus accomplish the same result. 

Since interest outlays vary in so many different ways, two 
complications arise. There are different rates of interest appli¬ 
cable to different transactions, and the sum of all these interest 
charges traceable to particular sections or instalments of output 
would not naturally be exactly equal to the whole interest 
burden borne by the business. As for the first point, economy 
and simplicity require selecting some fair representative fate, 
if interest is to be reckoned at all. Even if all possible variations 
could be reported, they would be disregarded when it came to 
fixing prices or deciding what improvements to make, just as 
the chance variations in direct costs are disregarded. And any 
details that would be of no use in making decisions are not worth 
collecting merely in the interest of abstract accuracy. Hence 
we come back to the position taken above: that where interest 
needs to be taken into account in studying the cost of producing 
goods, the complexities of financial arrangements had best be 
considered only for purposes of fixing a fair representative interest 
charge, and attention then focused on the productive use made 
of the funds. For some purposes, interest may fairly be ignored. 

5. LONG-RUN VERSUS SHORT-RUN FLUCTUATIONS 

In gauging the effect of added business on cost, it makes a 
great difference whether we are considering a long-run or a 
short-run policy. The wages and salaries of the indispensable 


44 


ECONOMICS OF OVERHEAD COSTS 


nucleus of the force are sunk costs which practically cannot 
be avoided, with reference to a short period. But with reference 
to a long period they would be a variable cost. Evidently time 
alters the definition of costs. In fact, the way in which costs 
behave in response to a 20 per cent increase in business is one 
thing if we have to deal with a 20 per cent increase in the output 
of a current month or three months, and a very different thing 
if we are talking about a permanent increase of 20 per cent in 
the total business, so that our ups and downs, our good years 
and our bad years, would all be on a scale 20 per cent larger than 
before. 

In the first case we should handle the output with our existing 
plant. On the other hand, a permanent growth of business will 
probably call for an extension of the plant, and this may itself 
produce an economy, but it will necessarily involve an increase 
in all those items that remained constant before. The long-run 
economies of large-scale production are like the short-run 
economies in this one thing: the added cost of the added business 
is less than the average cost, up to the point where economy 
ceases. But no one formula can possibly measure all kinds of 
cost movements. If it is right for short-run purposes it must 
be wrong for long-run purposes and vice versa. 

6, THEORETICAL OMNISCIENCE VERSUS 
WORKING APPROXIMATIONS 

One source of confusion lies in the fact that the economist, 
being a scientist with accurate observation as his dominant 
purpose and omniscience as his will-o’-the-wisp, tends to give 
terms the meaning they would have to an omniscient observer, 
forgetting that if such beings exist they have no need of his 
analysis. And the business man, wanting to know how much 
his costs will increase as the result of a given amount of business, 
but compelled to use inaccurate rules-of-thumb and rough-and- 
ready indexes, tends to describe these indexes in terms of what 
he wants them to tell him, either forgetting their limitations or 
forgetting that others will not be so familiar with their limitations 
as he is himself. 


COST AND DIFFERENT CLASSES OF COSTS 


45 


He commonly speaks of “variable costs” as if they were 
exact measures of the added expenses that will have to be 
incurred if certain extra business is taken on, when as a matter 
of fact, he may merely be speaking of a list of expenses which his 
cost accountants consider as varying somewhere near as much as 
business varies in the average case. Or he may speak of “ general 
expenses,” as the expenses that are “due to” the business as a 
whole and not to any particular part of it, although as a matter 
of fact, if those expenses vary, as a result of business having 
varied in amount, they are in part at least “due to” the volume 
of business, and the increases in general expenses are “due to” 
the particular extra business that caused the increase. The 
confusion in this case rises out of using the words “due to” in 
two different senses—the one implying physical tracing of effort 
to result, the other implying differential responsibility. 

In this connection, a student must not forget that any concep¬ 
tion of cost demands recognition if it has an actual effect on 
prices or policies of production, no matter if it is illogical or 
positively incorrect. Railroads may apply (and have applied) 
short-run conceptions of constant and variable costs to traffic 
policies which had long-run consequences. They assumed that 
two-thirds of their costs were not chargeable against added 
traffic, whereas in the long run, the major part of their costs 
were properly chargeable against it. Thus they have at times 
almost certainly taken some classes of traffic at less than cost. 
The “cost of production” that governs prices in such cases is 
not the true cost but an erroneous conception of cost, and an 
economist studying this situation should recogriize^the error 
as an actual economic force, at the same time that he strives 
to expose it. 

Modern cost accounting is on its guard against selling goods 
at less than they cost, and calculates costs with this in view. The 
result is a “cost” which allocates some overhead but not neces¬ 
sarily all. This “ cost” cannot be defined in terms of any coherent 
principle which the omniscient observer would recognize as a 
description of the facts. The only way to define it is to tell by 
what process it is arrived at and to estimate its pragmatic 





46 


ECONOMICS OF OVERHEAD COSTS 


effect. 1 Yet so far as it has an effect it is one of the most impor¬ 
tant types of cost for the student to consider, let alone the man 
of affairs. 


PART II. CLASSES OF COST 

After this preliminary survey of forces and points of view, 
we may next make a list of the chief classifications of cost which 
have to do with our main problem, and attempt to give them 
greater definiteness of meaning. 

7. OPERATING EXPENSES AND FIXED CHARGES 

This is one of the most widely used classifications though it 
does not cover the entire ground, for such items as interest on 
floating debt, and (in the case of railroads) hire of freight cars, 
are neither operating expenses nor fixed charges, but are included 
with fixed charges under the general head of “deductions from 
income.” In general, operating expenses include all outlays 
except taxes, rentals, interest, and certain kinds of losses and 
sinking fund appropriations, all of which are “deductions from 
income.” Taxes and interest on funded debt are the chief 
“fixed charges.” Depreciation and insurance are sometimes 
called fixed charges, but in the accounting system prescribed 
for railroads by the Interstate Commerce Commission they are 
treated as operating expenses, and the present study will follow 
that usage. The reckoning runs as follows: gross income less 
operating expenses equals net earnings of operation. Net 
earnings of operation less deductions (taxes, rentals, interest on 
actual debts, etc.) equals net corporate income (or deficit). 2 Net 
corporate income belongs to the corporation to do with as it 
pleases. 3 

For our purposes, the chief issue is the true nature of fixed 
charges, because they are often confused with “constant costs.” 
Fixed charges represent a minimum limit on the net earnings 

1 This topic will be taken up in section 16 below. 

1 Further adjustments are necessary to distinguish the earnings and costs of 
the primary business of the company from those of outside investments and outside 
operations in which it may be engaged. 

3 Subject to claims of minority stockholders if dividends are unduly wil 





COST AND DIFFERENT CLASSES OF COSTS 


47 


of operation below which they cannot go without insolvency. 
Nevertheless, they frequently do go below this level, with the 
result that there is a reorganization and the bondholders accept 
stock in place of part of their bonds, or some other adjustment 
is made that reduces the fixed charges, and the business goes on. 
Fixed charges obviously may cover a very large or a very small 
part of the capital invested. Two companies may have exactly 
the same investment, but one of them may have two-thirds of 
its capital covered by fixed obligations and the other may have 
no fixed obligations at all. For purposes of the financial records, 
the income account, and the balance sheet, there is an important 
difference between these two cases; but for purposes of cost 
accounting there is—or should be—none. 

Again, let us suppose a mercantile business which has a funded 
debt covering half its average capital investment. This business 
handles periods of extra heavy demand by renting additional 
floor space and borrowing additional funds for goods and working 
capital, with the result that in order to handle a io per cent in¬ 
crease of business the total investment will increase io per cent 
and the company will have to pay that much more in rentals 
and interest charges. It is obvious that additional business does 
not pay unless it covers its full quota of interest charges, and the 
fact that the bonds represent “a fixed charge” means nothing 
at all for the purpose of calculating the additional cost of added 
output. It is simply a low-water mark below which the interest 
charges cannot go, but there is nothing to prevent them going 
higher whenever and to whatever extent increased business 
makes necessary. 

Indeed they can go lower, even without a reorganization, 
in case the funds raised by bonds are not invested in permanent 
and specialized plants. If they are not tied up in this way, 
they can be taken out of the original business entirely and 
invested in securities during an off season. Or space in buildings 
and plant can be rented for some other industrial purpose, as a 
furniture store might lease surplus space for studios. The 
furniture company would still have to meet the interest on its 
bonds, but not solely from the furniture business. As an expense 





4 8 


ECONOMICS OF OVERHEAD COSTS 


of selling furniture, the interest on the bonds does not stand 
for an inexorable charge that cannot be reduced. So far as it 
can neither be reduced nor shifted upon some other source of 
earnings, it may be called a “minimum cost,” but it is not correct 
or appropriate to speak of it as a “ constant cost.” 

When one speaks of “ constant costs” and says, for example, 
that two-thirds of a certain class of costs is constant, that implies 
that a io per cent increase of business will increase this class 
of costs by about io per cent of 333 per cent, or 3! per cent. If 
two-thirds of the costs are constant and the other one-third 
varies three times as fast as business, the result is the same as if 
there were no constant cost at all. For illustration, we might 
suppose that the cost of “direct labor” in a certain plant varies 
exactly in proportion to output, but that the concern thinks it 
wise to put the most valuable and reliable men on a more perma¬ 
nent basis than the ordinary wage-earner and so gives monthly 
or yearly contracts to one-third of the men, making them in 
effect salaried employees. 

What has happened to the expenses? The total amount is 
still variable, exactly as before, with all ordinary variations in 
business. Added output costs its full pro rata share of the direct 
expenses. If someone who did hot know the facts were told that 
one-third of the cost of direct labor was constant and two-thirds 
variable, he would be quite misled, for he would naturally assume, 
for instance, that a 10 per cent increase in business would add 
only 6f per cent to the cost of direct labor, whereas in fact it 
would add 10 per cent. What has happened has no effect unless 
business shrinks to less than one-third its original volume, 
and then the expenses strike a minimum, though it may still 
be possible to reduce the expense of producing the particular 
goods in question by shifting part of this labor into some other 
kind of work. 

From this argument it is clear that minimum cost and constant 
cost both represent important facts but that they are quite 
distinct from each other. It is also clear that the minimum 
may be set by contracts the company has entered into and may 
have nothing strictly to do with the technical facts which deter- 


COST AND DIFFERENT CLASSES OF COSTS 


49 


mine the smallest cost at which a given kind of industrial process 
can be carried on. Interest on funded debt represents this kind 
of a minimum. 

8 . DIFFERENTIAL AND RESIDUAL COST 

When a decision has to be made involving an increase or 
decrease of n units of output, the difference in cost between the 
two policies may be considered to be the cost really incurred on 
account of these n units of business, or of any similar n units. 
This may be called the differential cost of a given amount of 
business. It represents the cost that must be incurred if that 
business is taken and which need not be incurred if that business 
is not taken. In figuring cost for this purpose, we must include 
any interest charge which is actually incurred in the one case 
and could be avoided in the other case. 1 It is clear that cost 
in this sense depends just as much on one of the proposed alter¬ 
native policies as it does on the other. The cost of continuing 
in business and turning out 100,000 units may be one thing if the 
alternative is to go out of business entirely, or it may be another 
thing if the alternative is to keep a nucleus of the force on the 
pay-rolls even if the plant is not running at all. 2 

To the general or financial accountant, such a conception 
of cost can hardly fail to appear forced, elusive, and unreal. It 
is not a tool adapted to his uses. But for the problems of eco¬ 
nomics or of cost-accounting in the broadest sense it represents one 
of the fundamental facts. One of the best expressions of the 
underlying idea was made at a conference on cost accounting 
in these words: “Whenever you exchange commodities or 
services and as a result have more assets than you would have 

1 Even if one absolutely refuses to count interest as a cost for any purpose, 
one must calculate added investment and judge if the probable earnings are enough 
to justify it: that is, judge if the probable gain outweighs the certain burden of interest 
on the added capital. 

3 This point will be developed later in a concrete case (see chapter viii below). 
This general idea of cost belongs in the same family with the concept of “oppor¬ 
tunity cost” of which H. J. Davenport has made a great deal ( Economics of Enter¬ 
prise, pp. 6t -65, 190-91). He also notes that the purposes of the general account¬ 
ant require him to use a different concept (“Farm Products and Cost Accounting, 
Journal cf Political Economy , XXVII, 354-61). 


50 


ECONOMICS OF OVERHEAD COSTS 


f 

had if the exchange had not been made you have realized a profit. 
This is not a problem in accounting but in business/’ 1 i * 

Some expenses may vary according to one dimension of the 
business and others according to a different dimension; for 
example, the terminal and haulage costs of a railroad, or the 
number of consumers and the number of cubic feet consumed 
in the case of a gas company. The differential cost of moving 
more trains per day is one thing and the cost of added tons per 
train is another, though wise management would maintain a 
balance between them as methods of moving additional freight, 
pushing each to the point beyond which the other would be 
cheaper. In the packing-house the differential cost of putting 
more steers through the plant is one thing and the separate 
differential costs of meat, hides, glue, fertilizer, and the other 
by-products are another thing, and the sum of these separate 
differentials would not equal the first sum. 

All costs not assignable by the differential method may , 
called “ residual costs.” Since differential cost includes interest 
on investment, without regard to whether it is or is not covered 
by bonds or notes and depending simply on whether a change 
in the business gives rise to an added need for capital, residual 
cost would naturally include interest on the entire investment so 
far as it has not been assigned differentially to some part of 
the product. 

One interesting case, already referred to, is the cost incurred 
in order to keep a nucleus of the working force together through 
a period of depression. This is in a very real sense incurred on 
account of all the business that may be taken on after the depres- 
tion is over, but hardly on account of any special amount of 
business taken at any particular time. In this connection when 
one estimates the cost of maintaining existing output, as com¬ 
pared to reducing it, one must not only deduct all costs that would 

1 C. B. Williams, in Year Book of National Association of Cost Accountants , 1921, 
p. 201. The italics are my own. Mr. Williams’ remarks show that this “problem 
in business,” as he conceives it, includes the liability of “spoiling the market” for 
future sales as one of the disadvantages of cutting prices. In this sense, good: 
sold at a price too close to their “differential cost” of production might not sho^ 
a profit. 


COST AND DIFFERENT CLASSES OF COSTS 


51 


continue if output were reduced, but also in some cases certain 
costs that arise out of the reduction itself. Labor turnover is 
a recognized cost, and is increased by irregularity of output. 
If it is a case in which the falling-off in demand is clearly tempo¬ 
rary, then anything which serves to keep any part of the force 
occupied instead of turning them off will reduce by that much 
the cost of building the force up again when business revives. 1 
Thus business which serves to fill up the hollow of a depression 
may be credited with a saving in some expenses that have not 
yet been incurred. This is clearly “not a problem in accounting, 
but in business,” for accounting can hardly be expected to rely 
upon quite such an uncertain bit of prophecy for such a radical 
act as making a deliberate deduction from current operating 
expenses. However, it seems clear that as a problem in business, 
goods may be worth producing which are not worth their “cost” 

t,s the accounts show it. 

* 

9. VARIABLE AND CONSTANT COSTS, FIRST MEANING 

This pair of terms has one possible interpretation which makes 
them practically equivalent to differential and residual costs as 
defined above, but it is gotten at by a different method. Starting 
with a search for certain accounting items which do not vary at 
all with variations in business and other items which vary in 
proportion to business, one soon finds that there are no items 
that remain permanently unchanged, few that remain unchanged 
for relatively short periods, and none that always vary exactly 
in proportion to business. As a result, every item of cost is 
bound to have a mixed character. 

This is expressed by saying, for example, that maintenaixe 
of way on railroads is one-third variable and two-thirds constant. 2 
This means that it varies as if two-thirds of it were entirely 

1 Discussed by Professor Paul H. Douglas, in “Personnel Problems and the 
Business Cycle,” Administration , July 22, 1922. 

3 See Ripley, Railroads , Rates and Regulation, p. 55. Later (p. 65) he says that 
while two-thirds of all the expenses are constant “at any given time” (meaning 
“over short periods ?”) over “a long period of years” it might happen, as Acworth 
concludes, that “nearly one-half of the total expenditures was entirely fixed in 
character.” 


52 


ECONOMICS OF OVERHEAD COSTS 


independent of the volume of business and the rest varied 
exactly in proportion. Such an expression has little meaning 
except within small ranges of fluctuation. Where fluctuations 
are appreciably large it becomes an arithmetical impossibility, 
for two-thirds of the expenses cannot remain constant and still 
remain two-thirds when the rest of the expenses vary. And 
one-third of the expenses cannot vary and remain one-third if 
'the rest are constant. 

What is really meant is that costs vary by about one-third 
as great a percentage as business does. If business increases 
6 per cent this class of cost increases 2 per cent and this is 
a good enough working formula, as long as one does not try 
to use it in a case in which the ratio of 2 per cent to 6 per 
cent no longer holds. If with expanding business we reach a 
point at which a further increase of 6 per cent will increase 
expenses in the same proportion, then all costs wall have become 
“variable.” 1 Perhaps it would be more correct to say that 
two-thirds of the expenses incurred under average conditions of 
operation are constant. This presupposes a fixed plant handling 
a traffic which varies within the limits of the plant’s capacity 
to handle it. The long-run growth of the traffic will require 
a larger plant, so that “constant costs” in the way of interest 
and maintenance will become variable in the long run. The 
larger plant may result in lower operating expenses, so that the 
costs which are “constant” over short periods may vary more 
in the long run than those which, over short periods, are “vari¬ 
able.” After the plant is enlarged, interest and maintenance 
at their new level may be just as unresponsive as before to subse¬ 
quent short-time changes in volume of traffic . The expression “con¬ 
stant and variable costs” is used most appropriately with refer¬ 
ence to short-run fluctuations of moderate amount. 2 

1 Evidently Dr. M. O. Lorenz is using terms in this sense when he speaks as if 
constant costs tended in the long run to disappear or to become variable. See 
his “ Constant and Variable Expenses and the Distance Tariff,” Quarterly Journal of 
Economics , XXI, 283 ff., esp. pp. 284 and 290. 

2 In Our Economic Organization, by L. C. Marshall and L. S. Lyon, the term is 
used in a general way so as to cover both the long-run economies of large-scale 
production and the short-run economies resulting from using the plant at full 



COST AND DIFFERENT CLASSES OF COSTS 


53 


IO. VARIABLE AND CONSTANT COSTS, SECOND MEANING 

Variable cost may be taken to mean a list of accounting items 
supposed to vary approximately in proportion to variations in 
business. Anyone familiar with business will recognize on a 
moment’s consideration that if he made out a list of variable 
costs wdth reference to minor fluctuations of business lasting a 
week or a month, he would have to revise it radically to express 
what would happen in case of a long-run growth in business lasting 
over a considerable term of years. Such a list of expenses can 
never be more than a rough approximation to the true differential 
cost of added business. Such lists are commonly made out 
consciously or unconsciously with reference to small and short- 
run fluctuations, and they make it awkward to speak about 
long-run changes, because one is forced to say that the “constant 
costs” have varied, while still calling them “constant costs.” 

✓ Constant costs would then include a list of accounting items 
supposed to remain very largely independent of business. Obvi¬ 
ously, if one item varies 45 per cent as much as business does 
and another varies 55 per cent as much as business does, these 
items might be difficult to classify. A conservative way of 
drawing the line is tajcount as constant costs only those items 
which are substantially unchanged by changes in business. If 
“constant cost” is estimated in this fashion, “variable cost” will 
be a great deal larger than the true differential cost of added 
business. Furthermore, in the long run no costs show this kind 
of constancy. Constdnt cost in this sense applies strictly to 
short-run fluctuations within the limits of the capacity of the 
existing plant. 

II. OTHER MEANINGS OF CONSTANT AND VARIABLE COSTS 

Some writers define constant costs as those costs which would 
go on even if the business stopped running. For some purposes 
this represents an important fact, but it does not have very much 

capacity, but the illustrations shown in the chapter on constant and variable 
costs are definitely short-run illustrations, and the explanation of the (long-run) 
economies of large-scale production includes this as only one out of many causes 
at work. 



54 


ECONOMICS OF OVERHEAD COSTS 




to do with the residual cost (or constant cost) which would appear 
if one calculated the added expense of taking on io per cent 
additional business when the plant is running at its average rate. 
What we really have to deal with here is a minimum cost rather 
than a constant cost, although “shutdown cost” would be even 
more descriptive. This minimum is itself somewhat indefinite, 
because the question how much expense it is worth while to 
incur in tiding over a shutdown depends entirely on how long 
the winter of discontent is likely to be and how warm a summer 
may be expected afterward. If the manager is confident of a 
quick and complete resumption, he may keep his foremen and his 
best laborers on the pay-roll, while if there are no very definite 
prospects of improvement he will merely try to keep the plant 
from serious deterioration with as little expense as possible. 

So far we have been speaking of variable and constant costs 
as costs that are or are not affected by the volume of business. 
However, costs vary from other causes, so that one meaning 
of constant costs would be costs that are not subject to variation 
from any cause. Variable cost would include costs varying 
with accidental conditions, and any costs over whose amount 
the management has control. 1 In the present study, there will 
be little or no occasion for making use of these particular mean¬ 
ings, especially as insurance is a most effective device for elimi¬ 
nating the purely accidental variations of cost and turning the 
cost of accidents into a constant charge on the producer. 

12. “sunk” costs 2 


This term suggests the fact that some costs may be elastic 
upward but not downward. Having once grown, they are not 
free to shrink again. This has nothing to do with the question 
whether they vary, in the direction in which they are free to 
vary, by a smaller or larger percentage than business varies. 
These “sunk costs” are primarily the costs on account of the 

1 These meanings have been suggested to the writer by some unpublished 
material on accounting by Mr. Paul Atkins, of the staff of the School of Commerce 
and Administration, University of Chicago. 


a This term is used by Harry G. Brown, Transportation Rates and Their Regula¬ 
tion , pp. II-I2. 



COST AND DIFFERENT CLASSES OF COSTS 


55 


permanent and specialized plant, and they mean that increases 
of cost due to increases of output beyond the capacity of existing 
plant, and decreases of cost due to decrease of output to less than 
the capacity of the plant, are governed by different laws. They 
also mean that even in the very long run there are some costs 
that cannot be escaped by going out of business. These might 
be called “ abandonment costs” to distinguish them from “ shut¬ 
down costs” where the shutdown is temporary. For some pur¬ 
poses, the cost of materials already bought or contracted for 
is a “sunk cost,” to the extent that it exceeds what the materials 
are now worth if sold or held for future use. 

13. URGENT AND POSTPONABLE COSTS 

The cost of materials must be incurred before the materials 
can be manufactured into finished products; likewise the labor 
that works them up must be paid, but the maintenance of the 
buildings and machinery may be done when the management 
pleases, within limits. However, in one sense such costs cannot 
be postponed. The physical deterioration of a plant goes on 
whether it is made good or not; and obsolescence reduces its 
value whether it is provided for or not. It is not the cost, but 
the making of it good, that is really postponable. The funda¬ 
mental purpose of a well-managed depreciation account is to 
take the postponing of such costs out of the discretion of the 
management by recording a regular accrual of depreciation 
whether the actual replacements in a given month or year are 
heavy or fight. Thus a good depreciation account minimizes 
the postponable expenses. In spite of all such devices, however, 
there is always some possibility of postponing outlays which 
are needed to keep the plant in good condition and thus virtually 
understating the expenses of a given year, and overstating the 
condition of the property. Or the opposite may occur and income 
may thus be concealed by putting it into betterments and calling 
them operating expenses. 

Even if the cost in the books is stabilized, it still makes a 
difference whether the actual spending of the money and doing 
of the work is fairly regular or is concentrated at certain times. 


ECONOMICS OF OVERHEAD COSTS 


' 56 

To be sure, stabilizing the account in the books removes the 
strongest motive for irregularity in the actual doing of the work, 
and this is one of the greatest benefits derived from a depreciation 
account. However, there is still no adequate positive motive 
for keeping this work regular; no motive, that is, corresponding 
in force to the interest the community has in regularization. The 
individual manager regards postponable expenses as life-savers, 
enabling him to retrench in hard times; but the life-saving is 
largely imaginary, for it is done at the expense of reducing 
employment and general buying power and so reacts by increasing 
the force of the depression, and ultimately becomes a boomerang. 

14. DIRECT AND INDIRECT EXPENSES AND 
KINDRED CONCEPTS 

Direct costs, as we have seen, are costs visibly traceable to a 
given job or order or class of business without the need of diffi¬ 
cult studies or allocations, but merely by watching the process. 1 
Certain materials go into certain finished products and certain 
workmen (and certain machines) spend certain definite amounts 
of time in working them up. On the other hand, the work of 
the central office, the power plant, watchmen and sweepers, and 
the sales force, is not so directly traceable. These costs are in¬ 
direct, though they may vary with changes in business. 

Direct costs are supposed to vary in proportion to the business, 
but while it is not far from the mark to assume in most cases 
that they do, still there are notable discrepancies. As we have 
seen, excess pay for overtime, or a decrease in output per labor 
hour on account of undue pressure and fatigue, may cause direct 
costs to vary more than in proportion to business. 2 This is a 
situation which would not be easily handled by the formula which 
says that such and such a percentage of costs is variable and such 
and such a percentage is constant. The idea of differential 
costs, however, furnishes a relatively simple way to handle it. 

If every job were charged with the cost of the particular labor 
directly spent on it, there would be an absurdity in the case of 
overtime unless the particular extra order that occasioned the 

1 See section 3 above. , 3 Ibid. 


COST AND DIFFERENT CLASSES OF COSTS 


57 


overtime work were always worked at in the overtime hours 
and at no other time. Otherwise the work immediately respons¬ 
ible for overtime pay would be charged at ordinary rates and 
other work not actively responsible would be charged with all 
the excess cost. This might be avoided by distributing the 
excess pay evenly over all the output, but this would fail 
to show the full differential cost of the work. The fact is 
that when a department is working overtime any work done 
by that department is equally chargeable with the full over¬ 
time rates, because that is what the company would save if 
any of the work were dropped. Here differential cost is greater 
than average cost (at least in this department), and differential 
cost multiplied by number of units of output is greater than total 
cost. So far as direct costs are concerned, the business has 
reached a stage of “diminishing return.” Such a situation 
cannot be handled by the accredited methods of accounting, 
which cannot allocate more costs than the total that has been 
incurred, even where the excess is more than balanced by other 
indirect costs which are not allocated at all. Yet when a plant 
has operated eight hours at standard rates and one hour overtime, 
there should be someone on the premises who could allocate nine 
hours of overtime pay without endangering his sanity, since with 
differential costs the whole need not equal the sum of its parts, 
and differential costs are important things to know about. 

There are various characteristics which may cause a given 
kind of work to be classed as an indirect cost. Four may be 
mentioned. In the first place, work may render a simultaneous 
service to different kinds of output or to the “business as a 
whole,” and it may be impossible to divide this service into parts 
except arbitrarily. Secondly, the work may serve one unit of 
business, but this one may benefit others. Thus different brands 
of goods advertise each other, or a legal decision sets a precedent 
that enables thousands of similar transactions to be made without 
further danger of lawsuits. 

Thirdly, the time spent on one thing may have little to do ^ 
with the value of that thing. This may be merely the result 
of irregularities and accidents, but it often involves some uncer- 


58 ECONOMICS OF OVERHEAD COSTS 

tainty whether the result will be gained at all (as in salesmanship 
or a lawsuit). Thus it is often dojubtful whether the work so 
far putfn has any value at all. It is, in a sense, a “sunk cost.” 
No matter how much effort has already been sunk, it still pays 
to put in more, up to the full value of the commission to be 
earned, the disputed propertybe secured, or other end to be 
gained. Thus one may “send good money after bad’' and end 
by spending far more thaji the whole Pesult is worth., 

Fourthly and lastly, it may simply involve too much time and 
trouble to separate the time spent on diluent bits of work, so 
that it is not worth while dqing. This is true where a worker 
turns from one thing to another ihany^Hmes a day, especially 
if they are different kihds of work, ^shop foreman’s time 
would not be worth trying to allocate even if it could be done. 
These are some of the reasons why some costs are not directly 
allocated. 

Besides the expressions already discussed one often reads 
of “prime and supplementary costs” and “special and general 
expenses.” These are both ideas of similar character. Special 
costs are incurred for particular parts of the business and general 
costs for the business as a whole. In practical usage, the oper¬ 
ating expenses of the central office come to be commonly spoken 
of as “general expenses,” although obviously there are many 
other costs which are not specially attributable to particular 
items of business. 


15. JOINT COST 

In the broad sense joint cost has been frequently spoken of 
as any cost incurred for the benefit of the entire business or of 
a considerable class of business as a whole, and not for its separate 
parts. Used loosely, the term may be virtually equivalent to 
untraced cost, or constant cost, or indirect cost . 1 In its origin, 
however, the term had to do with a special problem, namely, 
that of by-products, and it is more useful if it is confined to this 

1 The author has used the term thus broadly in his Standards of Reasonableness 
in Local Freight Discriminations , “Columbia University Studies/’ Vol. 37, No. 1, 
p. 24, but now prefers the stricter usage. This subject will be taken up more fully 
in chapter v below. 


COST AND DIFFERENT CLASSES OF COSTS 


59 


original meaning. 1 The savings of by-products are not the same 
as the general economies of producing one commodity on a 
large scale or the economies of utilizing a plant to its full capacity • 
They constitute a third distinct source of economy, arising where 
different joint products result from a single process and the econ¬ 
omy depends on turning them oi^Pm proper proportions —selling 
all the hides resulting from a given number of cattle slaughtered, 
and also all the meat, all 4he suet, an(J the other by-products. 
On a railroad eastbound and westbound traffic are joint, because 
it is cheaper to produc^hem together than separately, regardless 
of the total volume of tonnage rr^pved. But passengers and 
freight are not joint in t^samfe sense, because it would be cheaper 
to carry them separat^, letting one r#ad *?arry nothing but 
passengers and others nothing but freight, if roads could get 
adequate traffic in this way. Railroads carry freight and passen¬ 
gers both, simply because any increase in traffic is a gain, and it 
pays them to do so in spite of the diversity between different 
classes of traffic, and not because of it. 2 

16 . MANUFACTURING VERSUS SELLING EXPENSE 

It is a commonplace that the economies of increased output 
are largely responsible for the modern emphasis on selling 

1 See especially John Stuart Mill, Principles of Political Economy, Book III, 
chap, xvi, section i. Professor Taussig applied the term to railroad traffic in general 
(“A Contribution to the Theory of Railroad Rates,” Quarterly Journal of Economics, 
V, 443-45). He adopts a middle ground, making the term cover any case where 
overhead costs are large, so that added traffic brings economies, and where output is 
heterogeneous. But this usage precipitated lengthy controversies with Professors 
Seligman and Pigou (see Quarterly Journal of Economics, XX, 630-31; XXI, 151, 
155-82, 162-64; XXVII, 378-84, 535-38, 687-94). These disputes are inherently 
incapable of logical settlement, largely because the question, “When is output 
homogeneous and when is it heterogeneous ? ” when asked in abstract terms, can 
never be finally answered. One answer is: Output is heterogeneous whenever 
any differences exist which can be used as a basis for discrimination. But since 
discriminations may be based on the color of the customer’s skin, or the style of his 
garments, this would cover all cases of overhead cost, and rob the term “joint 
cost” of all special meaning. The only other point where a clear line can be 
drawn is the point at which heterogeneity of output becomes in itself a cause of 
economies. (See Edgeworth, “Contributions to the Theory of Railway Rates,” 
Economic Journal, XXI, 558, and Dewsnup, “Railway Rate Theory and Practice,” 
Political Science Quarterly, XXX, 476-509.) 

2 This point is more fully discussed in chap, v below. 


6 o 


ECONOMICS OF OVERHEAD COSTS 


especially for the attempt to capture nation-wide and world¬ 
wide markets. After a plant is once installed, the cost of opera¬ 
tion depends on the success of the selling force in marketing 
enough goods to utilize the equipment adequately. Thus over¬ 
head costs in production stimulate the producer to increase the 
overhead costs of selling. Beyond this introductory common¬ 
place, there is room for a great deal of useful study in describing 
the true relations of these two departments of a business, and 
of the corresponding costs. If economics has paid insufficient 
attention to overhead costs of production, it has definitely ignored 
the costs and services of selling goods, in formulating the formal 
laws of value. 1 

Some goods are not produced until they have been sold 
(e.g., “made-to-order” clothing, locomotives and other special 
machinery, and most construction work), others are not sold 
until after they are made, being “made to stock” in the first 
instance. Even in such cases, however, a concern likes to get 
orders ahead. Where goods are made only to order, production 
depends on sales in a more immediate and imperative way than 
when they can be made to stock; thus there is pressure to sell, 
but no compulsion to sell below cost. On the other hand, when 
unsold goods are piling up, there comes a point when continued 
production depends upon moving the existing stock off the 
shelves. With this pressure to sell goes the further fact that 
the cost of production is now a “sunk cost,” and may not be 
recoverable at all. Hence it no longer sets a minimum limit on 
price. Thus direct costs of manufacture may, on occasions, 
be treated as overhead, where selling comes after production. 

These special cases, however, do not affect the two underlying 
facts: first, that selling costs must be added to costs of manufac¬ 
ture and prices must cover them both in the long run; and, 
second, that the cost of selling combines several of the essential 
characteristics of an “overhead cost,” so that accountants 
commonly treat it as “burden,” and allot a given rate, or per¬ 
centage, to cover it. In the first place, the selling effort is quite 

1 Cf. G. B. Dibblee, The Laws of Supply and Demand, pp. 50-74. Mr. Dibblee 
emphasizes selling as an overhead outlay. 


COST AND DIFFERENT CLASSES OF COSTS 


61 


like a battle, and its economics are of the same variety as the 
economics of a barrage fire. It only takes one bullet to kill one 
man, if it hits him, but “it takes a ton of lead,” counting the 
bullets that miss. And the bullets that miss are just as necessary 
as those that hit, because no one can tell, when the ammunition 
is served out, which will find a mark. 

In selling, the bullets that hit must pay for those that miss, and 
in many kinds of selling effort the hits are a small percentage, so 
that most of the expense must be allotted. Advertisers do their 
best to trace the shots that hit, not for purposes of crediting the 
sale to a particular letter or interview, but chiefly to judge the 
relative productiveness of different advertising media, or of 
different types of appeal. In personal selling or in individual 
advertising via the mails, there is a chance to distinguish between 
customers as to whether they are good or bad “prospects” 
for future efforts, but here again a man who has responded once 
seems to remain indefinitely on the lists of prospects, and some¬ 
times the effort spent upon him is inversely proportional to the 
subsequent response. The “marginal” or doubtful buyer, like 
the independent voter, is the critical field for selling effort. In 
any case, such tracing of appeal and response in advertising is 
not used or useful in determining the direct cost of single sales. 

In the second place, when the selling effort is made, the pros¬ 
pective buyer is commonly offered a choice between different 
types of goods, and until he exercises his option and sends in his 
order, the producer cannot tell what particular product he was 
engaged in selling, and, therefore, cannot charge the cost of the 
preliminary steps against a specific piece of work in the factory, 
or a particular brand of goods on the shelves. This is not true 
when goods are sold before they are made, but in such cases there 
are other sufficient reasons for treating selling cost as overhead. 

In the third place, since selling to doubtful buyers is often 
a matter of “summation of stimuli,” a given amount of effort 
may bring no result at all unless more is sent after it. If there 
is any clear estimate of the amount of effort which is worth 
expending to make a given sale, then as soon as that much has 
been spent it becomes a “sunk cost,” and it then is worth while 


62 


ECONOMICS OF OVERHEAD COSTS 


to spend as much more, if necessary, in order to bring the sale 
• to pass. Thus the aggregate effort often mounts up to far more 
than the sale would justify. 

In the fourth place, selling effort is often regarded as a long¬ 
time investment in “good-will.” Sales made today do not stand 
alone; if they mean satisfied customers they mean future sales. 
If this good-will were a tangible asset it would be carried on the 
books at cost, and depreciation would be charged on it, based on 
its probable term of life. As it is, one cannot tell with certainty 
what is the cost properly chargeable to capital in such a case. It 
costs something to maintain good-will, but how much is a matter 
of guesswork; hence it is uncertain how much of a given year’s 
expenses is a current charge and how much has really gone into 
increasing the company’s intangible assets. And the obsoles¬ 
cence of good-will is more insidious and far more uncertain than 
even the obsolescence of a machine. Thus it is unsafe to record 
good-will as a capital asset, at least until it has had a considerable 
time in which to demonstrate its value. Hence expenses for 
building it up must, for the most part, be charged as current 
costs, not as capital outlays, and hence the accounts carry ele¬ 
ments of cost which need not, as a matter of business policy, be 
justified by the business of the particular year in which they 
were incurred. 

In the fifth place, goods help to sell each other, so that 
advertising is not wholly separate from the selling of goods. A 
sale may itself be a bit of advertising. Free samples are an 
obvious example, while “leaders” furnish a distinct economic 
problem. Is it fair to sell goods at less than cost, or at unduly 
low margins, in order to push other sales ? A “leader” is gener¬ 
ally a commodity that is standardized and well known: either 
something homogeneous like sugar or a branded article which 
has a customary price, so that the customer is sure to be aware of 
any bargain that may be offered him. To make this kind of 
advertising profitable the same concern must sell other goods, 
which are less standardized or not so well known, where the loss 
on the “leaders” can be made up without attracting the cus¬ 
tomer’s notice. This means that retail trading is the chief 


COST AND DIFFERENT CLASSES OF COSTS 


63 


indicated field for this kind of selling tactics, for here one 
concern sells a considerable variety of products, and the customers 
are better acquainted with some than with others. 

Sixth, selling costs, and the results gained, are immensely 
variable, so that the worth of a given effort has very little to do 
with its cost. This has already been recognized as a character¬ 
istic of indirect expenses. 

One type of advertising which is clearly general in character 
consists of cultivating a favorable public opinion toward the 
company, without direct reference to the price or quality of 
particular goods. Concerns attempt to educate the public as 
to their methods of production and welfare work, the size and 
character of their organization, and its history and traditions, 
and they sometimes lend their advertising space to publicity 
for some matter of purely public interest. The concern may 
hope to benefit via the market or via the legislature: It may 
avoid the danger of harmful legislation, or it may sell more goods 
to persons who prefer to deal with a concern of good public 
character; one which has an esprit de corps; one which does more 
than the letter of its bond requires, and bears its share of com¬ 
munity burdens. If this kind of publicity is properly a cost at 
all, it is clearly indirect. 

One type of selling expense is direct and variable; namely, 
commissions paid to agents or salespeople on the basis of volume 
of sales. Sometimes this is varied by granting a special premium 
for disposing of “ stickers”—goods which have remained unsold 
longer than they should. This may be a more effective way of 
pushing these goods off the shelves than to give the same premium 
to the customer in the shape of a lowered price, though, if so, the 
fact is a sad testimonial to the consumer’s judgment of qualities. 
At best, however, the result must be to divert selling effort from 
better and newer goods, which would yield better results in the 
long run. It is an attempt to protect the normal margin above 
the original cost of the goods, when that cost has become a 
matter of ancient history. The low-priced basement depart¬ 
ments, which many large stores now operate, furnish a more 
logical avenue for the disposal of such goods. 


64 


ECONOMICS OF OVERHEAD COSTS 


17. COST IN THE SENSE USED BY COST ACCOUNTANCY 

Since cost accounting systems differ in what they include, 
it is difficult to frame a definition that will cover all cases. Cost 
in this sense always includes direct cost plus a percentage of 
indirect cost which is allocated in some uniform fashion. The 
system may undertake to allocate everything, including interest 
on the entire investment, or it may stop at operating expenses. 
Apparently, progress is in the direction of allocating everything, 
including interest on the investment. 

Cost as conceived by this type of cost accounting appears to 
represent an amount such that if the company can charge that 
much and get it, on what is considered to be a “ standard” rate 
of output, the business may be regarded as in a satisfactory 
financial condition. The investment will “pay,” and the original 
decision to embark on the business will have justified itself and 
recompensed all sacrifices involved. Under ordinary circum¬ 
stances, this cost is supposed to be treated as a minimum below 
which prices will not be cut, but this minimum presumably has 
some elasticity, since it is not always possible to make a given 
return on the investment and in that case it is not good business to 
hold to a rigid price policy at which the market will not take the 
goods. Cost in this sense comes very near the economist’s idea 
of normal price or value, and this implies that actual prices 
will be below it about as often as above. Where cost accounting 
confines itself to operating expenses and does not include interest 
on the investment, the managers must make their own allowance 
for the necessary profits, and their prices must necessarily run 
considerably above the level of “cost.” 

The cost accountant’s problem is a difficult one. He has 
to furnish evidence on questions of policy where differential costs 
are the important thing and yet differential costs cannot be a 
part of his original records, for these can only set down what 
happens, and not engage directly in comparisons with the past 
or conjectures for the future. He is responsible for reporting 
present facts in such form as to help the management avoid two 
opposite errors—that of selling goods at a loss and that of 


COST AND DIFFERENT CLASSES OF COSTS ' 65 

setting a price so high as to prevent some sales when the concern 
would be richer if it had sold the goods at a lower price. 1 

In furthering the first purpose, cost accountants have evolved 
the system of allocating “burden.” “Burden” includes indirect 
operating expenses and also interest, when interest is treated 
as a cost; and every item of output has a share of burden allotted 
to it on some basis that seems reasonable and appropriate. But 
this process might go too far, and violate the second purpose of 
cost accounting by charging goods with a share of costs that are 
constant, and losing sales that would more than cover the vari¬ 
able or differential costs involved. Goods might seem to cost 
more in time of depression merely because constant costs are 
divided among fewer units of output, although to raise prices 
at such a time in order to cover the constant costs would be a 
manifest absurdity, and would defeat its own end. In partial 
recognition of these facts, cost accountants commonly charge 
each unit of goods, not with the actual burden divided by the 
actual output, but with a “standard rate,” covering what the 
burden ought to be at normal or “standard” output. Thus in 
time of depression not all the burden is distributed; some is 
left “unabsorbed.” 

Cost as reported in the cost accounts becomes, then, direct 
cost plus the goods’ share of the standard burden. It is not the 
same thing as cost in the sense used by the general accountant 
or by the economist. It is not a pure record of fact but contains 
arbitrary quantities and elements of judgment or conjecture 
It is not total cost nor differential cost nor variable cost nor 
direct cost. It is a species by itself, and its justification must be 
wholly in terms of the purposes it serves. 

PART III. CONCLUDING QUESTIONS 

l8. IS INTEREST A PART OE COST? 

It is perfectly clear that from the point of view of that kind 
of cost accounting which seeks to discover a satisfactory price, 
interest on the entire investment is included. This is equally 

J Another duty is that of furnishing a conservative inventory value of goods in 
process. 




66 


ECONOMICS OF OVERHEAD COSTS 


true from the point of view of an economist seeking for the laws 
of natural price. On the other hand, the Federal Trade Com¬ 
mission does not include interest as a cost. 1 Their chief purpose is 
to discover what the actual earnings have been with a view to 
deciding whether they furnish evidence of monopolistic extortion. 
For this purpose interest on debts means little, while figures 
of total investment are none too reliable. Moreover, even if 
these figures were accurate, the Commission is hardly in a position 
to determine a fair rate of interest for many different industries, 
with the inevitable implication that all earnings above this rate 
are excess profits. This might seem premature, in view of the 
fact that the courts have the last word. But if they publish 
earnings as a percentage on investment, then argument can be 
joined as to whether this is more than a fair return under all 
the conditions prevailing in each particular case. And so far 
as correction might be needed for errors in the figures for invest¬ 
ment, such correction would be put in a simpler form. 

As for differential costs, it is perfectly clear that any com¬ 
parison of cost between two different rates of output or two differ¬ 
ent production policies may involve a difference in investment, 
and the interest on this difference is an essential item in the com¬ 
parison. It is impossible to estimate the cost of producing goods 
by labor-saving machines as compared with the cost of produc¬ 
ing them by hand unless the interest on the machinery is taken 
into account. In calculating differential costs, interest may be 
the same on both sides of the reckoning and so cancel out, or 
there may be a balance on one side or the other, which becomes 
a part of differential cost. Differential cost may include more 
than operating expenses, or less. 

On the other hand, from the point of view of financial account¬ 
ing, governed as it is by the legal liabilities of the business, it is 
clear that interest on bonds and notes is a cost in a certain sense, 
but interest on the investment represented by stock is not a cost, 
from that standpoint. The economist has no need to quarrel 

1 Cf. statement of Dr. Francis Walker, Yearbook of National Association of Cost 
Accountants , 1921, pp. 75 ff. His chief arguments are: (1) Accountants are opposed 
to it. (2) Uniformity is desirable. (3) For the commission’s purpose in detecting 
extortionate gains, interest is a “profit.” 


COST AND DIFFERENT CLASSES OF COSTS 


67 


with the accountant’s usage in the matter of the income account, 
provided that usage is not extended beyond its proper field 
and imposed upon cost accounting and cost analysis in such a 
way as to distort their data and warp their findings. 

Among enlightened accountants the question whether interest 
is a cost appears to be reducing itself to a question whether it 
shall be so set down in the books from which the formal income 
account and balance sheet are made up, or whether it shall be 
separately taken account of in particular calculations wherever 
needed in analyzing the facts of cost for any particular purpose. 1 
That is, it is admittedly an element in cost analysis , though not 
necessarily in the general books of account. If it is not reckoned 
in the books, it must be added for certain purposes, and if it is 
reckoned in the books it must be subtracted again for certain 
other purposes, so that in intelligent hands the question becomes 
largely one of convenience. 

19. COST FROM THE STANDPOINT OF DIFFERENT PURPOSES 

We have seen that the cost-accounting conceptions of cost 
do not agree with cost as used by the general accountant, and 
that they disagree because they are wanted for different purposes. 
The different ideas can be combined in the same statement if 
the cost accounts do not include interest, by first reckoning the 
direct cost and the burden allocated to particular items of ouput 
and then adding the “unabsorbed burden.” The result would 
be the total operating expense. If the cost accounts include 
interest on the entire investment as part of the burden, the 
harmonizing of cost accounts and general accounts would not 
be so simple, because the general accounts cannot very well 
include interest on the stockholders’ investment as a cost. Of 
course, there is no absolute need to harmonize them, even though 
they must both be built up from the same basic records. There 
are, in fact, minor discrepancies permitted, even where interest 
is not treated as a cost. 

This is really necessary, even from the standpoint of cost 
accounting alone, for it has conflicting purposes to serve within 

1 Year Book of National Association of Cost Accountants , 1921, pp. 45~9^ 
esp. pp. 90, 92-3. 


68 


ECONOMICS OF OVERHEAD COSTS 


its own technique. Costs are used to set a value on goods in 
process or awaiting sale and this value must be conservative. In 
this matter the banks set standards to which business is obliged 
to conform if it wants to get credit, requiring that inventories 
shall exclude interest or report it separately. Another considera¬ 
tion is the feeling that prices should normally be above cost, and 
that prices below cost are an absurdity. So that where good 
business judgment dictates certain prices and these turn out 
to be below the nominal “cost,” that seems to show that the 
cost accounts have something very queer about them. Since 
sound business judgment may at times dictate selling goods at 
barely more than their differential cost, cost accounts would be 
revolutionized if this principle were taken at its face value. 
Both these considerations are in hopeless conflict with the idea 
of cost as an amount that would be a satisfactory average price 
to charge. 

This being the case, the thing to do is to cease trying to make 
one concept do the work of several. After all, the obligations 
a corporation must meet before dividends are paid are one thing, 
and the whole financial outgo or sacrifice attributable to the act 
of producing certain goods is another thing, and a conservative 
standard for valuing unsold goods is still a different thing. 
Undoubtedly the ultimate solution lies in the development of 
systems of cost analysis which shall be separate from the formal 
books of account, though based on the same data. This analysis 
will be free to study differential cost and cost as a normal supply- 
price, without being tied down by the rules that are legitimate 
and necessary in financial accounting. 

The economist also uses both these conceptions because they 
represent forces governing price. One is a long-run standard, 
the other a natural minimum limit on short-run fluctuations. 
Abandonment costs play an important part in determining who 
the typical marginal producer is, and shutdown costs furnish an 
incentive to maintain production in off times, and a measure of 
the waste of unemployed capital, so far as it is borne by the busi¬ 
ness enterprise. 


COST AND DIFFERENT CLASSES OF COSTS 


69 


The statistician, as such, has no characteristic purposes, but 
he has a technique peculiarly adapted to the study of differential 
costs. The engineer has to deal with the total cost (in the econo¬ 
mist’s sense) involved in new enterprises, and with comparisons 
of total cost for different kinds of plant, or for different policies 
in a going concern where some change of the plant is involved. 
He must therefore take account of interest on investment. Thus 
he deals with total cost and with differential cost, but the canons 
of general accounting are foreign to his needs. 

20. CONCLUSION 

If this overlong discussion has justified itself, it should have 
shown why there cannot be found one universal meaning for 
"cost of production,” and it should have helped the reader, when 
he encounters the many current usages, to translate them if 
necessary into consistent language and to recognize whether 
any given conception of cost is being used for its proper purpose 
or is being abused. We next turn to the different laws governing 
the variation of cost and especially the different "independent 
variables” whose changes bring about changes in costs of 
production. 


t 



CHAPTER IV 

THE LAWS OF RETURN AND ECONOMY, OR 
THE VARIABLES GOVERNING EFFICIENCY 

SUMMARY 

Introduction, 69—The elastic limits of productive activity, 72—Reciprocal 
relation of the factors, 73—Unlimited capacities of labor and unspecialized capi¬ 
tal, 76—Twelve variables governing efficiency, 79—Importance of distinguishing 
these variables, 83. 

I. INTRODUCTION 

One of the most important aspects of overhead costs is the 
fact that increased output commonly brings increased efficiency 
or decreased expense per unit. Here we are dealing with what 
economists used to call the “law of increasing return,” the law 
which was once supposed to be characteristic of manufactures 

t * 

in contrast with agriculture. In this study we shall not use this 
terminology, because it suggests an antithesis with the “law of 
diminishing return,” where none exists. The two laws are not 
measured on the same yardstick; diminishing return commonly 
refers to such units as bushels of wheat per laborer, or horse¬ 
power per pound of coal burned; while increasing return typically 
applies to bushels of wheat per dollar expended, on labor , land , 
and all other means of production (cost per bushel), or ton-miles of 
freight moved per dollar expended on coal, engines, rails, ter¬ 
minals, labor of all sorts, and all other sources of expenditure 
(cost per ton-mile). Therefore, when the terms “increasing or 
diminishing return” are used in this study, they will refer pri¬ 
marily to physical results achieved per unit of some technical 
factor of production, or of some group of factors representing only 
a part of the total expenses of production. 1 Thus it will never 
be a measure of the economic efficiency or financial economy of the 
whole process. Where we are dealing with the return per dollar 

1 This distinction is made by F. M. Taylor, Principles of Economics, 2d ed., 
pp. 137, 149-50* 


7o 


THE LAWS OF RETURN AND ECONOMY 


71 


expended for all purposes, we shall speak of efficiency or economy 
or cost, not of “return.” 

Where “diminishing returns” refers not to some single homo¬ 
geneous physical factor such as fertilizer or plowing, but to a 
more general “factor” such as capital or labor, it is no longer 
a purely physical law. These general factors are really groups 
of the simpler factors, tied together by the principle of substitu¬ 
tion at existing market prices. This gives increased elasticity. 

Since “diminishing return” refers only to a part of the factors 
of production and therefore covers only a part of the total cost, it 
is easy to see why it may go hand in hand with increasing economy 
in the whole expenditure, if the other elements in cost remain 
constant while output increases. 1 Decreased yield per laborer 
does not condemn intensive farming if it brings increased yield 
per acre, for where land is expensive, the net result may be an 
economy. In quite the same way, overtime work in a factory 
may bring decreased yield per hour of direct labor or per dollar 
spent on direct labor, but total cost per unit may be reduced 
because the permanent plant and the “indirect labor” involve 
large elements of constant expense. Direct costs per unit 
may increase while indirect costs per unit are diminishing. 

For this and other reasons, it has long been evident to econo¬ 
mists that to speak as if there were two “laws of return,” a “law of 
increasing return,” and a “law of diminishing return” is inade¬ 
quate, inappropriate, and confusing. A law should describe the 
way something acts, and where there are a number of different 
things that act differently, the way to distinguish one law from 
another is by the different things that do the acting. The fact 
is that there are a great many things worth studying as independ¬ 
ent variables, each of which affects output in its own particular 
way and each of which accordingly has its own law—or group of 
laws, for each plant may be to some extent a law unto itself. 
Each “law” may go through a stage of increase and a stage 
of decrease either in technical return or in general economic 

1 See Carver, Distribution of Wealth, pp. 87-89. “Diminishing return” as 
commonly used typically expresses the effect of changing proportions of the produc¬ 
tive factors: “increasing return” reports the effect of increased total output. This 
distinction is stressed by Carver (ibid., pp. 65, 76, 90-91), Davenport (Economics of 
Enterprise, chap, xxiii), and others. 



72 


ECONOMICS OF OVERHEAD COSTS 


efficiency, as the case may be. Some of these principles have 
been confused seriously in the past. 

2 . THE ELASTIC LIMITS OF PRODUCTIVE ACTIVITY 

If there is any general principle underlying all these laws, it is 
that economies result from developing the unused capacities of 
productive factors, and that the exploitation of the capacities 
of any factor encounters elastic limits and increasing resistance. 1 
In particular, one may lay down the proposition that whenever 
a productive factor which costs something has any unused capa¬ 
city which can be developed without encountering unduly increas¬ 
ing resistance, there is an opportunity for financial economy 
in utilizing that capacity. Resistance becomes “undue” when 
the differential cost of added output becomes greater than aver¬ 
age cost (including a pro rata share of the cost of the constant 
factor). 

So far as free goods are concerned the question of unused 
capacity simply does not arise, because we never utilize such 
things up to the point of increasing resistance. Indeed, that is 
the reason why they are free. Not merely such things as air and 
water, but the underlying forces of nature may be regarded as 
free goods. Natural forces have unlimited capacity and, up to 
the limits set by patents and secret processes, the knowledge of 
how to utilize them is free: a community asset. However, the 
equipment to harness these forces has limited capacity, and this 
includes all the tangible economic factors of production. 

This common fact of developing the latent capacities of a fac¬ 
tor of production in the face of increasing difficulty appears under 
many guises. The “law of proportion of factors” refers to 
getting more results out of one factor (for example, land or a 
locomotive boiler) with the help of increasing amounts of another 
factor (for example, farm labor, or coal fired under a boiler), 
with the result that, in general, the more we get out of the land, 
or the boiler, the less we get out of each laborer or each pound 
of coal. In studying this process, two facts of prime importance 
stand out. The first is that while the capacity of some factors 

1 Cf. F. M. Taylor, op. cit., pp. 136, 138. 


THE LAWS OF RETURN AND ECONOMY 


73 


has definitely fixed limits, such as the heat contained in coal, or 
the products of any chemical reaction, or the tractive power of a 
given locomotive on the best possible roadbed; other factorsV 
seem to have no assignable limits on their capacity, depending 
only on how much of the complementary factors are lavished 
upon them. 1 The second fact is that there is a reciprocal rela¬ 
tion between the extent to which the capacities of different factors 
are utilized; that the capacity of one factor can be fully utilized 
only by having some other factors working at relatively low 
efficiency. 


3. RECIPROCAL RELATION OF THE FACTORS 

This is a universal law which holds good throughout all forms 
of production. It was originally seen in the case of land, where 
the ultimate capacity of the laborer could be attained if he had 
unlimited quantities of land to farm, resulting in a relatively 
low crop per acre; while the ultimate capacity of land could be 
approximated by farming very intensively, with the result 
of a relatively low crop per laborer. In the same way, if more 
time and care is spent in economizing materials, a given amount 
of materials will produce more finished product, and no plant 
ever uses its materials so very' carefully as to utilize absolutely 
100 per cent of their possibilities. It would be wasteful to do 
this. It would not pay to spend ten dollars’ worth of labor 
to save two dollars’ worth of materials, although the result 
would increase the “efficiency” of the materials, if we look 

T The chemical aspect of the law of proportion of factors is best treated by 
Carver, who shows that if two elements are put together in the exact proportions 
in which they combine to make a given compound (e.g., oxygen and gasoline in a 
carbureter), not all of either element will be combined, but there will be an uncom¬ 
bined residue of both. An excess of one will increase the percentage of the other 
that is taken into combination, though, of course, it means utilizing a smaller 
percentage of the element that is in excess. Thus chemical combinations obey the 
law of “diminishing return.” The chief point of this illustration is that elasticity 
exists even where we should least expect it. There is elasticity in the usefulness of 
factors supplied, even where there is none in the amounts ultimately utilized. 
See Carver, Principles of Political Economy, 1919, p. 367; Principles of National 
Economy , pp. 437-83. He cites the manufacture of ether from alcohol, which is 
expensive, and acids, which are cheap, where the acids are used in excess of the 
chemical proportion. 


74 


ECONOMICS OF OVERHEAD COSTS 


at it solely from this point of view. If the materials were to go 
up in price until what was worth two dollars before came to be 
worth twenty, then it would pay to spend ten dollars’ worth of 
labor to economize the same amount of material which before it 
paid to waste. 

Part of the efficiency of a garment cutter consists in planning 
his cuts so as to economize his material, but it would not pay 
him to spend all day in order to save a few inches. That is, 
it would not pay unless perhaps there were going to be hundreds 
of identical garments cut, so that a few inches of cloth per garment 
would be worth more than his day’s labor would cost. There is 
another side to this same illustration, for by giving the cutter 
more cloth per garment, he can do his cutting with less perfect 
planning and therefore more rapidly, and can turn out more 
garments in a day’s work. Thus, with more cloth to work with, 
the inherent capacity of the cutter is more fully developed. 
Perhaps, by giving him 20 per cent more cloth and letting him 
work more rapidly and less carefully, he could turn out 16 or 
18 per cent more garments in a week. 

An interesting case, illustrating this principle, was reported 
by Mr. E. W. Dudley, in a paper on “Wastes in Air-brake 
Service.” 1 After describing the waste due to leakage in this 
country, he said: 

They don’t know what leakage is in Europe. One of your best known 
members told me of riding on a French railway locomotive during the war 
and being almost paralyzed to see the engineer calmly reach over and shut 
the throttle valve in the air compressor steam pipe shortly after leaving 
the station. There was about 80 lbs. pressure in the system and there it 
stayed until the brakes were used to make the next stop, when the pump 
throttle was opened up and the pressure restored. There were no leaks— 
they were not tolerated. Why? Because at that time coal was $64 per 
ton and the engineman received a bonus on every pound he could save. 
So it can be done. 

We avoid the cost of a good tight pipe job, of close inspection and of 
competent repairing, but burn more coal. We need to do more than make 
rules about these things. We must have the right kind of men, enough of 
them, .and encourage them by giving them the tools, the materials, and the 

1 Paper read before the 1922 Convention of the Air Brake Association, reported 
in Railway Age, June 20, 1922, p. 1606. 


THE LAWS OF RETURN AND ECONOMY 


75 


proper places to do the work. No man can turn out a decent job with 
only a pipe wrench, a paint brush and a lack of proper material or con¬ 
veniences. 

Here we have a clear statement of the need of spending more of 
some factors in order to economize others, and of the importance 
of the cost of each factor in governing methods of production. 

Or, we might take a machine as an example. We can develop 
the latent capacity of the machine by spending labor lavishly 
to see that it has a continuous supply of materials and that it 
can always get repairs the instant they are needed and is watched 
ever}' minute. This would mean that machine tenders would 
not be taking care of as many machines as they might, and it 
would mean that the repair force would be quite large and might 
spend a great deal of its time waiting for something to go wrong. 
It would mean that the capacity of the machine tenders and the 
repair men was being imperfectly utilized in order to utilize more 
fully the capacity of the machines themselves. 

On the other hand, the management might try to have every 
laborer tend as many machines as possible. As a result, the ca¬ 
pacity of the laborer would be brought out much more fully, but 
the machines might not work as well. In spinning, the chief 
knack of the frame tender is to tie up broken threads quickly. 
By installing an automatic device that stops the machine when a 
thread breaks, one man has been enabled to tend more frames. 
But an automatic stop costs something, so that capital increases 
faster than output. With such a device, it would be physically 
possible for one man to tend an unheard-of number of spindles, 
but machines would spend a considerable percentage of the time 
idle, waiting for the machine tender to get around to tie up the 
thread and start the machine again. It is evident that the 
product per man can be made very high on condition that the 
output per machine (and even more, the output per one hundred 
dollars invested in machinery) should be relatively low. 

Similarly, if the repair force is to be kept extremely busy and 
is to make a high record of efficiency, in the sense of repairs 
accomplished per man, the size of the force will be very small 
compared to the amount of equipment they have to take care 


76 


ECONOMICS OF OVERHEAD COSTS 


of, and when a machine needs repairs it will have to wait its 
turn until the repair force finishes other work, so that the per¬ 
centage of idle time for the machinery and the active operators 
will be increased. In other words, in order to utilize the capacity 
of the repair force most efficiently, the rest of the plant would 
work at something less than the greatest efficiency of which it 
was capable. Here we have two possible types of inefficiency, 
one where the repair force is so large that nobody ever has to 
wait for repairs, while the repair men spend most of their time 
idly waiting for something to do, and the other where the repair 
force does not waste any of its time, but keeps the machines and 
their operatives waiting. Somewhere between these two types 
of inefficiency there is a balance; a point of maximum economy in 
terms of the total cost of machinery, repair men, and active 
operators. 

When it comes to retailing, there is a final party whose effi¬ 
ciency is to be considered; namely, the consumer. Each sales¬ 
man may make more sales where there are so few of them that 
most of the customers have to wait a long while to be served. 
This means that the customers’ time is used inefficiently: a 
burden they are likely to resent out of proportion to the value of 
anything they might have done with the wasted minutes. Here 
the point of true efficiency is hard to determine, lacking a money 
measure of the worth of the customers’ time. 

4. UNLIMITED CAPACITIES OF LABOR AND 
UNSPECIALIZED CAPITAL 

In the days of handicraft industry, tools were not so expensive 
but that every craftsman could own a fairly full equipment. 
If a number of craftsmen had gotten together and used one set 
of tools between them, the capacity of the tools would have been 
more fully utilized—the output per saw and per hammer would 
have increased—but the loss of human efficiency would have 
more than outweighed the gain. With the introduction of the 
gigantic engines of modern industry, the efficiency of the tool 
becomes much more important and the output per laborer is no 
longer the decisive feature of the case. The expensive machine 


THE LAWS OF RETURN AND ECONOMY 


77 


cannot afford to stand idle as large a percentage of the day as a 
carpenter’s saw or hammer or chisel. The proportion of things 
must be so adjusted that its capacity is much more fully de¬ 
veloped. 

But another much more significant change results from 
machinery. Mechanical work is limited by the source of power, 
and with the advent of this iron slave we have freed the capaci¬ 
ties of labor from the limits set by animal power—his own or 
that of his beasts of burden. As a result, small amounts of 
either labor or capital will suffice for enormous works if there are 
unlimited amounts of the other factor to work with because the 
other factor can, if necessary, furnish the bulk of the power. 
The pyramids were built with primitive mechanisms and untold 
labor: the capacities of a little capital were brought out in a 
way that amazes modern observers, but the efficiency of labor 
was low, and the cost in labor was lavish. Today the opposite 
trend prevails, and single laborers control unheard-of masses 
of power and with it perform miracles, though the product per 
unit of investment in machinery is diminishing. 1 

Still more significant, perhaps, is the fact that human labor 
comes to be more and more a matter of overseeing and guiding 
the iron slave; the laborer has in fact become a supervisor. But 
work of supervision is commonly spoken of as an “overhead 
cost.” It does not vary definitely with output. No more 
effort is necessary (though more may be profitably spent) to 
plan for turning out an order of a thousand window sashes than 
a hundred, no more brainwork to decide to adopt a patented 
fire-extinguishing system for a plant with a million square feet . 
of floor-space than for one with ten thousand. For essentially / 
the same reason it costs no more labor to steer the greatest liner 

1 The figures of the census bear this out to the extent of showing a progressive 
decrease in value of products per dollar of capital invested as capital per establish¬ 
ment and per laborer increases. There is perhaps no absolutely satisfactory way 
in which to measure investment in modem machinery and compare it with that of 
fifty or two hundred years ago, for dollars have changed their purchasing power, and 
other standards are open to criticism. However, if the equipment of the handi¬ 
craft era were reproduced and put in service today, a fair comparison would be 
possible in terms of dollars invested; and there is not a shadow of doubt that the 
result would verify the above statement. 


78 


ECONOMICS OF OVERHEAD COSTS 


than a motor-boat, and not nearly as much as to steer a Gloucester 
fishing schooner. A man with a shovel could perhaps -unload 
from thirty to thirty-five or forty tons of coal in a day. The 
same man in charge of an ordinary bucket and crane can unload 
five or ten tons in forty seconds or less, while at the controls of a 
car dumper he may be able to “oversee” the dumping of a 
fifty-ton car every minute of the day, if there are that many 
cars to be dumped. When labor takes the form of supervising 
the harnessed forces of nature it may become an “overhead 
cost” like any other form of supervision, largely independ¬ 
ent of variations in the amount of force that lies under its 
control. 

S® far we have been speaking of some of the more general 
aspects of the development of unused capacities, chiefly in rela¬ 
tion to the proportions of different factors used with each other 
in production. This fact is also clearly at the basis of the idea 
of constant costs as distinct from costs which vary with output. 
A railroad track is a stock illustration, and it is commonly 
assumed that railroad plant in general is a constant asset and 
that the labor of operating trains varies with traffic. However, 
the only way to secure full utilization of the track is to run 
heavier and heavier trains, and this means that rails, ballast, 
cars, and locomotives all grow heavier and more expensive while 
the yard tracks and station buildings increase in harmony. 

As a result, the nearest thing to a really constant outlay that 
can easily be found in the long run is the work of the locomotive 
engineer and fireman. This varies somewhat in one sense. 
A mechanical stoker may become necessary with larger loco¬ 
motives, and a differential wage may be established; neverthe¬ 
less this item of labor-cost is more nearly constant, with changing 
trainloads , than any capital item is, in the long run. And since 
the number of trains that can be efficiently run on a given track 
is a relatively stable item, increasing trainloads are one of the 
necessary ways of handling increased traffic, except where it is 
very sparse. One might say that the latent capacity of the 
engine-crew is developed by giving them a bigger locomotive to 
handle and more freight to haul. 


THE LAWS OF RETURN AND ECONOMY 


79 


5 - TWELVE VARIABLES GOVERNING EFFICIENCY 

Without attempting to cover all the variables which govern 
industrial efficiency, there are certain fairly tangible ones whose 
effects have something to do with overhead costs. Am ong 
these twelve are worth mentioning here. 

a) The proportion between different productive factors. —The 
law governing this variable is commonly called the law of di¬ 
minishing return, though it has stages of increasing and con¬ 
stant returns. 

b) The percentage of the full capacity of the plant which is 
utilized. —This may be called the “capacity factor.” 1 It ap¬ 
pears either in connection with short-run fluctuations of busi¬ 
ness or with building in advance of expected growth, because 
in the long run the size of the plant would adapt itself to any 
steady rate of output. The economies of full utilization are 
commonly spoken of as a “law of increasing returns,” although 
the same term is also used to cover the general economies of 
large-scale production, and there is frequent lack of adequate 
distinction between these two cases. We shall not speak of it as 
a “law of return” at all, but as a law of economy or cost. 

c) Steadiness or fluctuation in the rate of output. —The chief 
measure of this is the “load factor,” or ratio of average 
output to maximum output during a given period. 2 This is 
coming to be a much-used term with its related ideas of “peak 
load” or “maximum demand,” and of “off-peak business” as 
contrasted to business that comes “on the peak” (at the time 
of maximum demand). These terms are self-explanatory, and 
they are intimately related to the capacity factor because, as 
we have just seen, fluctuations of output are the chief cause of 
plants working at less than full capacity. However, it is worth 
while to distinguish them for some purposes, chiefly because 
there are some cases in which it is possible to adopt deliberate 
policies looking ahead and definitely aiming to steady the rate 
of output, and others in which the behavior of demand is so 

1 G. P. Watkins discusses these terms in his book, Electrical Rates (New York, 
1921), pp. 12-14. 

2 See G. P. Watkins, op. cit. 






So 


ECONOMICS OF OVERHEAD COSTS 


unpredictable that all that can be done is to treat each week or 
month of low demand as a problem in itself, trying to mitigate 
the losses due to unused capacity. 

d) The number of units produced of a given size, type, brand, 
or model of goods in a given plant. —This has reference, not 
solely to increasing the total size and output of the plant, but to 
the sort of economy a business can secure without expansion, 
simply by reducing the number of different sizes or models they 
turn out; in other words, by “standardization.” There are 
costs incurred on account of each size or model that do not vary 
with the number of units of each size turned out. Such costs 
are general so far as concerns the different units turned out from 
one model, though special to this model as over against other 
models. There are such expenses as molds and patterns, the 
changing of rolls, the making of drawings and specifications, and 
part of the costs of storage. Increasing the total size and 
output of the establishment brings savings on all these scores, 
but reducing the number of models will also bring them. 
Standardization is strictly a manufacturing economy. In 
selling, the most effective use of the salesman’s time and talents 
may still be found where he handles a full and varied line of 
goods. 

e) The proportion of different products turned out by some 
central process or plant. —Wherever two or more different prod¬ 
ucts can be produced more cheaply together than apart, not 
because of any general savings of increased output but because 
these particular sorts of product are complementary to each other, 
there we have “joint cost” in the strict sense. One way of 
putting it is to say that every added unit of product A makes it 
easier than it would otherwise have been to produce added units 
of product B 1 This principle covers the rotation of crops, 
packing-hous by-products and similar cases of by-products, and 
may overlap the problem of fluctuating demand, where the kind 
of service that can be rendered at one time is essentially different 
from the kind that can be rendered at another time. As, for 

1 See Edgeworth, “ Contributions to the Theory of Railway Rates,” Econ. 
Jour., XXI, 558, and Dewsnup, “Railway Rate Theory and Practice,” Pol. Set. 
Quarterly, XXX, 476-509 


THE LAWS OF RETURN AND ECONOMY 


81 


example, the use of electric current for lighting at night and for 
power in the daytime. 

/) The size of the single plant. —A large plant, working at 
full capacilyfrwill usually differ in efficiency from a small plant 
’working at full capacity, on account of the difference in size 
of the two plants. Normally the advantage is on the side of the 
larger plant. In most industries, a fairly large concern has a 
vast advantage over an extremely small one, and in some indus¬ 
tries an enormous investment is required in order to obtain 
standard efficiency. Strictly speaking, this means that there is 
a different law for every industry and perhaps even a different 
law for every plant in every industry. However, there are some 
general principles which can be discovered, and there is always a 
limit of size beyond which gains are negligible. Sometimes, how¬ 
ever, one concern would absorb the entire market before it reached 
this limit. 

g) Integration or vertical combination. —Here there are im¬ 
portant economies to be had, distinct from the other economies 
of large-scale production, and they also appear to have their 
limits. Integration has proceeded far in the steel industry, 
while the advertising firm and the industrial engineering firm 
are examples of the opposite tendency; making an independent 
business out of what used to be simply parts of the work which 
the management of any business did for itself. 

h) Horizontal combination. —The combining of plants carry¬ 
ing on generally similar kinds of production (plants that would 
naturally compete with each other) is another element which 
commonly makes possible some economies, but which may reach 
its limit in somewhat the same way as the economy resulting 
from the size of a plant. Economies in purchasing, in research 
organization, in giving the larger organization the benefit of 
the best managerial ability and the saving of cross -freights, are 
commonly spoken of as savings of this sort, but they may be 
limited by the difficulty of organization over great distances. 
Or particular plants may carry standardization farther than they 
could if independent, each specializing on certain types of goods 
while the combination still makes it possible for the salesman to 



82 


ECONOMICS OF OVERHEAD COSTS 


“carry a full line.” This involves giving up the “saving of 
cross-freights,” so that the management must choose which 
saving is the greater . 1 These savings should be carefully dis¬ 
tinguished from the next law. 

i ) The extent of competition or monopoly. —This, in itself, 
has an important effect on productive efficiency, distinct from 
its effect on prices. Like the previous case it is made up of 
opposing elements. The savings of horizontal combination may 
go so far that one all-absorbing combination seems to be naturally 
more efficient than anything smaller. Moreover, there are wastes 
of competition as such, which can only be saved by extinguishing 
it. These are largely wastes of selling tactics. On the other 
hand, the attempt to gain complete monopoly itself contains 

v elements of waste, chiefly because the would-be monopoly must 
buy up not only the best plants but the relatively inefficient 
ones also. As a result, in most cases concentration would prob¬ 
ably stop short of complete monopoly even without the com¬ 
pulsion of law. 

j) Geographical concentration of industry. —Efficiency also 
varies according to the output of a given industry in a given town, 
or district, or nation, apart from the internal economy resulting 
from the large size of particular plants. Under this general 
heading come different sorts of gains; some in production and 
some in bargaining, buying, or selling; some dependent chiefly 
on the volume of output in a given area and some chiefly on the 
number of competitors who are concentrated in such an area. 
They include the “external economies” of large-scale production 
(increased efficiency in auxiliary industries, development of a 
generally qualified labor supply, etc.) as distinct from the 
“internal economies” dealt with under “size of single plant.” 
One important feature of these external economies is that they 
accrue, not to any one producer, but to all in this industry. The 
person who creates them does not absorb the main benefit 
in the same way in which the person who builds up a large 
plant absorbs the benefit in the way of economy resulting from 
its size. 

1 This is discussed more fully in chap, vi below. 


THE LAWS OF RETURN AND ECONOMY 83 

k) Geographical density of population and industry in general, 
in its effect on the general efficiency of the economic system. —This 
is not a thing capable of definite measurement, for it includes 
products of different kinds and there is no common yardstick. 
The dollar will not serve this purpose, chiefly because it is as 
much a measure of increasing scarcity as of increasing output; 
as much a token of poverty as of abundance. We have here a 
general resultant of more intensive agriculture, subject to dimin¬ 
ishing returns (which in this case means increasing costs also) 
and of various internal and external economies in stores, factories, 
schools, newspapers, theaters, etc. It is clear that civilization 
gains in economic efficiency from greater density of settlement, 
considerably beyond the point where agriculture begins to show 
rising costs, but it would be hopeless to attempt to pick out a 
point of maximum effectiveness. 

l) Degree of co-operation between industries of different sorts, 

and different industrial groups or classes. —Wherever there are 

» 

matters of common interest which can be better attended to by 
joint than by separate action, there is a sort of social overhead 
cost. Many of these joint activities, including the most funda¬ 
mental and necessary ones, are carried on by the state, but many 
remain in private hands. The amount of effective co-operation 
depends partly on the range of different industries developed 
within a town or nation, partly on the area over which effective 
interchange and communication is possible, and partly on the 
number of different functions which people are willing to handle 
co-operatively. The nation is the natural limit of most economic 
co-operation, but for some purposes the economic community 
crosses national boundaries and establishes a wider area of com¬ 
mon action. 

6. IMPORTANCE OF DISTINGUISHING THESE VARIABLES 

This classification is not by any means exhaustive, but it 
does indicate some of the chief lines of division between the 
different problems of efficiency with which economists have to 
deal. At least this much classification is needed for the sake of 
clearness. As we have seen, there is one law that determines 


8 4 


ECONOMICS OF OVERHEAD COSTS 


how intensively it pays to cultivate land under given conditions 
(proportion of factors), and another law that determines the 
limits of economical size for farms, and these are two distinct 
laws. The internal economies of large-scale production must be 
distinguished from external economies, for they lead to consolida- 
tion and sometimes to monopoly while the external economies 
have nothing directly to do with monopoly (except so far as they 
consist of internal economies in subsidiary industries). The 
internal economies come to the producer who is responsible for 
them, while the external economies are largely free gifts made by 
single producers to industry in general. One raises the question 
of cut-throat competition and monopoly; the other raises the 
question of protection or subsidies to stimulate industrial pioneer¬ 
ing which is worth more to industry as a whole than the pioneers 
can ever hope to collect in profits. It would be confusing to 
speak of these two very different laws indiscriminately as 
examples of the law of increasing returns or of the economies of 
large-scale production. 

Again, the case of joint costs or by-products leads to charging 
what the traffic wili bear as between different products, but not 
as between different persons, and it does not lead to cut-throat 
competition, provided the industry is in such a state that a 
proportionate increase or decrease in all the products turned 
out carries with it a proportionate increase or decrease in costs. 
What does lead to cut-throat competition and to personal dis¬ 
crimination is the condition in which the general volume of 
business can be increased or diminished without adding or sub¬ 
tracting its full pro rata share of costs. Competition of packers 
may bring down the price of various by-products, of bones, horns, 
and bristles, but it will not naturally go so far that the total 
income from a steer is less than the total cost of all the processes 
involved, merely because a large part of the cost is joint. 

Unused capacity is another story, and it may lead to cut-throat 
competition in any business, with or without joint products. 
The economies of utilizing unused capacity are very great, while 
the economies of increased size are spectacular only in the early 
stages where plants are still small. Yet railroads may bid for 


THE LAWS OF RETURN AND ECONOMY 


85 


increased business on the basis of the economies it brings them 
when they have unused capacity, ignoring the cost of capital 
on the ground that this is a constant outlay, at the same time 
that they are raising millions of capital for the enlargements of 
their plants which their growing traffic makes necessary. Again, 
an increase of general business is one thing, and off-season 
business or “off-peak” business, which can be counted on to stay 
off season or off-peak, is a very different thing. Off-peak 
business might be profitable at prices that would mean a loss if 
applied to general business. So it seems that it is of practical 
value to keep these different variables distinct, aside from the 
more academic advantages of avoiding ambiguity and sterile 
controversy. Let us now look more closely at the way in which 
some of these variables behave, with a view to formulating the 
laws governing them, so far as they can be formulated in general 
terms. 


CHAPTER V 

THE LAWS OF RETURN AND ECONOMY —Continued 

SUMMARY 

Proportion of factors in relation to overhead costs, 86—Plant capacity and 
steady utilization, go —Standardization, 96—Joint cost, 98. 

I. PROPORTION OF FACTORS -IN RELATION TO 
OVERHEAD COSTS 

When the law of proportion of factors is stated, one factor 
is usually taken to be constant and another variable: for example, 
a fixed area of land and a variable amount of labor. This means 
that for purposes of short-run problems, at any rate, land repre¬ 
sents a constant cost and labor a variable one. The land is, 
paradoxically, “overhead.” As labor per acre increases, the 
crop per acre naturally passes through five stages. It may 
increase (1) faster than labor, (2) just as fast, (3) slower, (4) not at 
all, or (5) it may actually decrease. The first case represents in¬ 
creasing returns to labor; the second represents constant returns, 
the third diminishing returns, the fourth zero returns, and the 
fifth less than zero returns. 1 

1 Increasing returns to factor A implies less than zero returns to factor B, 
constant returns to factor A implies zero returns to factor B, diminishing returns 
to factor A implies diminishing returns to factor B, and so on through the other 
two cases. For a development of this mutual relationship, see F. M. Taylor, 
op. cit ., pp. 126-35, esp. 130, 133. Taylor mentions only three stages, corre¬ 
sponding to the first, third, and fifth given here. The second and fourth are, 
very strictly speaking, only transition stages; nevertheless in many simple and 
definite mechanical and chemical combinations where there is one best proportion 
and a minimum of elasticity, all combinations worth considering would approximate 
either the second case or the fourth and there would be a sudden jump from one to 
the other. If men are moving dirt in wheelbarrows, each ma n needs one wheel¬ 
barrow. If there are fewer barrows than men, output is limited by the number of 
barrows and if there are fewer men than barrows, output is limited by the number 
of men. Even here there is some secondary need for spare barrows, and some other 
sources of elasticity. In a large plant, if some costs are constant and others vary 
in proportion to output, then the variable costs represent factors in stage two, and 
the constant costs represent factors in stage four. Plants are typically in approxi¬ 
mately this condition. 


86 


THE LAWS OF RETURN AND ECONOMY 


87 


But note what the “law of proportion of factors” says of 
these stages. The fifth stage is manifestly inefficient, and the 
first, its converse, is inefficient for the same reason. In stage 
one there is not enough labor to develop the land and what labor 
there is would raise more if it let part of the land lie idle. Stage 
two, or constant return, is also inefficient, if land costs anything, 
because, while the crop per laborer is at its maximum, it would 
be just as great with a little less land, and so whatever that little 
land costs is a clear loss, yielding no addition to product. Or 
with more labor the cost would be less per bushel, since the 
“variable cost” of labor would be the same per bushel and 
the “constant cost” of land would be divided among more 
bushels. 

For the same reason stage four (the converse of two) is ineffi¬ 
cient if labor costs anything. Therefore maximum financial 
efficiency is reached after the return per laborer has begun to 
diminish, but before it reaches zero. The exact point will be the 
point at which the “variable cost” (differential labor cost) per 
bushel for the last added bushel of crop is equal to the average 
cost of the whole crop, including the rent of the land. Thus the 
“law of diminishing return” holds good, not as a purely technical 
principle, but as a principle of human choice. The most eco¬ 
nomical combination is one in which all the factors are in a stage 
of diminishing return. 

Now something very like this happens when a factory of a 
given size is run at varying rates of output; from next to nothing 
up to the point where further efforts at speeding up defeat their 
own ends. Some costs are roughly constant, and so long as a 
given increase in variable costs produces a corresponding increase 
in output (“constant returns”), there is increased economy; 
and the maximum has not yet been reached. This condition is 
thought perfectly natural in the factory, and unnatural on the 
farm. Why? Chiefly because a factory typically sets a price 
and sells what it can at that price while a farm raises a crop and 
markets the whole crop at whatever it will bring above the cost 
of harvesting and shipping. Thus one does not think of a farm 
plant working at part capacity because the market will not take 


88 


ECONOMICS OF OVERHEAD COSTS 


the product at a profitable price, at least not habitually, as is 
the case with a factory. 

Another answer is that the land of a farm is not an indivisible 
organic unit in the same way in which a factory is. Therefore if 
one is farming too much land, the mistake can be corrected by 
letting some of it go, renting or selling it. A factory or a railroad, 
on the other hand, is an organized unit. It cannot be divided 
without being partly crippled, nor reduced in size without becom¬ 
ing qualitatively different from what it was, and a less effective 
instrument. A single-track railroad running four trains a day 
each way is more efficient than a similar road running only two 
trains. But if this gain were merely a matter of proportion of 
track to trains, the two-train road could have secured it by mak¬ 
ing its original investment smaller. This would have meant a 
narrow-gauge road; more fully utilized, to be sure, by smaller 
trains and more of them, but with a corresponding waste of the 
train-crews’ labor, and the further burden of a costly added trans¬ 
fer to connect with the standard-gauge system of the rest of the 
country. Thus it may pay to incur the inefficiency of two trains 
a day rather than the inefficiency of a narrow-gauge line. 

It is often necessary to weigh incomplete utilization of an 
efficient type of plant against full utilization of a plant so small 
as to be inefficient. And one of the fundamental reasons why a 
small plant is so often inefficient is that it fails to utilize the full 
supervisory power of that indivisible element, man, when he 
might have more powerful iron slaves at his disposal. There are 
many reasons why so many manufacturing concerns are smaller 
than is necessary for maximum efficiency. One is the number 
of concerns that have made small beginnings in the hope of grow¬ 
ing to maturity, and another is the fact that the standard size 
has been growing, in harmony with advancing mechanical 
methods, so fast that it is hard for concerns to catch up. 

On the farm this particular disturbance to the law of pro¬ 
portions does not commonly arise, because in most branches of 
agriculture a moderate-sized one-family farm can be about as 
efficient as a very large one, so that there is not the same necessity 
for taking up more land than one can cultivate that there is for 


THE LAWS OF RETURN AND ECONOMY 


89 


building a standard-gauge railway even if one cannot find traffic 
to utilize it adequately. Moreover, a farmer is never limited 
by the extent of his market as a railroad is, or even as a manu¬ 
facturer often is; his market is not his own private affair, and 
his output has no perceptible effect on the total supply and cannot 
possibly produce a glut all by itself; therefore it pays him to 
raise all he can and sell it for what it will bring. 

Nevertheless, proportion of factors has something to do with 
size even in farming. The methods of extensive cultivation 
(little labor on much land) lend themselves to larger farms than 
do the methods of intensive cultivation, largeness being measured 
not merely in area of land, but in total gross output, or any other 
rational measure of size. This is because extensive farming 
can employ machinery for its cruder and less discriminating 
operations, and can use hired labor with less loss of efficiency or 
less need of eternally vigilant supervision. Furthermore, on 
small farms efficiency is almost typically limited by inability 
to get enough working capital for the minimum efficient working 
force—commonly the farmer’s own family. Here is an inefficient 
proportion of factors. More capital would bring “ increasing 
returns.” But it is hard to get more capital, and the proportion 
cannot be improved by reducing the amount of labor without 
reducing the working unit to an inefficient size. 

There is another reason why, in manufacturing, plants are 
not commonly working with just the output (and just the pro¬ 
portion of factors) that means the greatest efficiency. Fluctua¬ 
tions of demand make the operations irregular, and the size of 
the plant cannot adapt itself to them. 1 Does this affect farms ? 
They are exempt from weekly or monthly fluctuations of demand, 
but there certainly are good and bad years in different branches 
of agriculture, and to some extent years of heavy or light plant¬ 
ing; yet the size of farms (and of the farmer’s family) cannot 
adapt itself with perfect elasticity. There are undoubtedly 
important parallels between agriculture and manufacturing in 
this respect, as well as important differences, but a search for 
them at this point would lead too far afield. 

* See Taylor, op. cit p. 151; cf. also Torrens, On Wages and Combinations 
(London, 1834), p. 63. 



90 


ECONOMICS OF OVERHEAD COSTS 


To sum up, we have seen that the law of proportion of factors 
and the law of efficient size of output are distinct principles, but 
related to each other. Where one of the factors is an organic 
unit, which cannot be made smaller without changing it into a 
different and less efficient kind of instrument, this fact may set 
minimum limits on the efficient size of an establishment. 1 Never¬ 
theless, a manufacturing plant may be in a stage of increasing 
efficiency with increased output, and decreasing returns with 
reference to the proportion of factors, both at the same time, and 
a farm may be in a stage of decreasing return with intensity of 
cultivation while an increase in the size of the farm would yield 
increasing economy of production. 

2 . PLANT CAPACITY AND STEADY UTILIZATION 

What is the “capacity” of a plant? Business men use the 
term constantly, and yet no absolute figure can ever be set. 
The term never means the utmost limits to which production 
could be pushed; there is always some “overload capacity.” 
The forces that set the limits on capacity are various. In 
electrical generating machinery the limit is set by overheating, 
with the result that the machinery can be run for a few minutes 
at a faster rate than it could stand as a regular running speed, 
because it takes some time to raise the temperature to the 
point of injuring the machinery. In the case of ordinary manu¬ 
facturing there are three main ways of increasing output; namely, 
working more shifts, working a given shift longer hours, and 
speeding up the pace of the work. This is a little like the 
temporary overloading of a dynamo, in that when labor works 
excess hours, or works at undue speed, there is an accumulation 
of fatigue, although the result is a matter of days and weeks 
instead of minutes. 

If we work our labor force overtime we shall probably have to 
pay them higher wages per hour for the extra work, or they may 
get tired and not work as effectively, while a night shift is 
notoriously less efficient than a day shift. So in one way or 
another we shall find that the cost of operation increases. At 

1 See F. M. Taylor, op. cit., pp. 134, 141-42. 


THE LAWS OF RETURN AND ECONOMY 


91 


some point there will be a balance between the increasing cost of 
operation and the economy due to more perfect utilization of the 
machine itself. At that point the differential cost of added out¬ 
put will be equal to the average cost, including all overhead 
costs on account of the machine itself. Beyond that point, it 
will pay to get more machines. This point might furnish a 
theoretical measure of capacity, but one that would be hard to 
apply. It would be a zone of some width rather than a point, 
and in the long run it would call for a working day considerably 
shorter than would pay for a short spurt. 

For practical purposes, capacity must be measured according 
to what is a customary length of working day for the machinery, 
which may be anything from eight hours a day to twenty-four. 
Thus in a plant where eight hours is the standard operating day, 
normal capacity would mean eight hours’ output, and this could 
be increased by putting on a second and a third eight-hour shift, 
while a plant already working two shifts does not have the same 
reserve of producing power. The same principles apply to stand¬ 
ard or satisfactory speed, meaning, as nearly as can be deter¬ 
mined, the maximum speed which it pays in the long run to try 
to secure. Presumably, the ideal of the efficiency engineer 
would be the highest speed that could be maintained year in and 
year out, that is, without producing cumulative fatigue; but 
nobody knows exactly what this is, and working estimates must 
needs be governed by customary practice. 

In considering fluctuations in the utilization of a given plant, 
all costs depending purely on the size of the plant will remain 
constant. This would include taxes, interest, and for practical 
purposes, insurance, depreciation, and general expenses. The 
critical question, however, is how the variable costs behave, 
and what the limits of increased output are. This depends on a 
number of circumstances, including the question whether it is a 
short-run or a long-run problem, and whether the output of this 
particular plant is low at the same time that industry in general 
has reached the low stage of the business cycle, or whether it 
moves independently. It also depends on whether the industry 
uses time wages or piece wages. 


92 


ECONOMICS OF OVERHEAD COSTS 


For instance, in an industry which does not use a piece wage 
but hires by the day, it may not be practicable to reduce the work¬ 
ing force every day when business happens to be slack, and take 
men on again at a moment’s notice when business becomes heavier. 
Under such conditions, operating expenses may not vary at all 
with reference to very short-run fluctuations in business, up to 
the point where the force has to work overtime or where green 
men have to be hired. When that point is reached, expenses 
will take a sudden upward jump, increasing much more than in 
proportion to the business that created the overload. Yet if 
business were to fall off and remain steadily low for an entire 
month, the working force would be cut down, or if business 
remained high for an entire month, more men would be taken on 
and given a modicum of training, overtime would be avoided, 
and operating expenses would increase little, if at all, faster than 
volume of business. 

In a force of day-workers, there is some elasticity in the 
amount of work a given force will do in any one day or week, 
and therefore some margin between the point where some workers 
would be laid ofl, and where additional ones would be taken on. 
A temporary overload might not cost the employer anything in 
extra wages—for the moment. And often when the strain at 
one point goes beyond these limits, it can still be met by calling 
men from other points where the load is still within this elastic 
margin of tolerance. Thus a large mail-order house shifts “ order- 
pickers” as they may be needed from groceries to dry goods or 
hardware or elsewhere in its array of different branches of mer¬ 
chandise, but any general increase in business will require 
overtime or an increase in the force. 

Postponable work offers interesting possibilities of mitigating 
the effects of fluctuations. Such work may be directly remunera¬ 
tive, so that if it is postponed it amounts to postponing output as 
well as costs. Some, like maintenance, may be indirect, so that 
output goes on for the time being virtually undisturbed. In 
some cases, output may be more interrupted by making repairs 
than by letting them go, so long as the machinery will work at 
all. So far as repairs can be concentrated in slack times, the 


THE LAWS OF RETURN AND ECONOMY 


93 


waste of irregular operation is mitigated. For most purposes, 
however, such work can be put into the time before and after 
regular working hours, and would not be held for a period of slack 
business; nevertheless, the use of postponable work has many 
possibilities. 

In this respect the managing staff stands on a different foot¬ 
ing from the rest of the force. The executives commonly 
work overtime without excess pay when overtime work is needed, 
and in slack times they not only shorten their hours but catch 
up on certain kinds of postponable work which has been allowed 
to fall behind in the pressure of filling urgent orders. It is in 
dull times that operating systems are overhauled and inefficient 
methods weeded out. There is a natural deterioration in stand¬ 
ards of work which it requires eternal vigilance to correct, and 
this deterioration is often allowed to go on in busy times and 
checked up later when the staff has more time. Thus, while 
the general expenses of the managing staff may show no change, 
with moderate fluctuations in business, there is an imponderable 
cost which escapes the books. The business done in rush times 
is not quite so profitable as the books will naturally show, nor 
are the expenses incurred during slack times all chargeable 
against the small volume of business that is then being done. 

Another disturbing fact is that, when men are being laid off, 
the ones that are left work harder for fear of losing their jobs, 
especially when industries in general are also laying off men, so 
that the loss of a job is a more serious thing than in active times. 
The Ford Motor Company, after its shutdown of 1922, turned 
out more work with 40,000 men than with 57,000 before the shut¬ 
down. 1 A contributory cause is the fact that the most capable 
workers are kept, and that some superior men are shifted to 
inferior jobs commonly held by far poorer workers. More than 
one case is on record in which the force was cut twice and both 
times the total output increased instead of decreasing. 2 In 

1 See Paul H. Douglas, “Personnel Problems and the Business Cycle,” Adminis¬ 
tration, July, 1922, p. 22. The company turned out as many cars as before and 
“many more parts.” 

* Ibid., pp. 22-23. Numerous cases of increased output per man are cited. 


94 


ECONOMICS OF OVERHEAD COSTS 


general, the behavior of operating expenses represents chiefly a 
compromise between savings due to this fact and wastes due to 
the loss of proper proportion between the different parts of the 
working force: between the cutting edge of the tool, so to speak, 
and the auxiliary services of power, transmission, storage, plan¬ 
ning, supervising, and what not. Because these forces are so 
complex, differing from plant to plant, no generalization can be 
made as to just how the curve of operating expense behaves when 
plants work at different percentages of their normal capacity, 
except the fact that when the overload becomes great, cost 
always increases faster than output. 

In general, probably, we should not be very far wrong if we 
made a careful estimate of costs which do not vary at all with 
changes in the capacity factor, and then took for granted that 
other costs varied in proportion to output up to the point of 
congestion. On some such basis as this, Ripley estimates for 
railroads that two-thirds of the expense of maintenance of way 
and structures are constant, half of maintenance of equipment 
and conducting transportation and all of the general expenses, 
making about 55 per cent of the total operating expenses. 1 
In most businesses, the percentage of constant operating expenses 
would not be so high. 

From what has already been said a reflective reader would 
deduce that, aside from any loss of efficiency due to working a 
plant at less than full capacity, change itself brings either gain 
or loss, and probably more often loss. When a cut in the force 
increases the per capita output from 35 per cent to 120 per cent, 
this looks like a spectacular gain, but there is an unseen debit. 
One reason why there is so much room for increase is that men 
nurse their jobs in order to postpone a possible cut in the force 
as long as possible. Thus the fear of a cut leads to soldiering 
before the event and speeding up afterward, and the loss un¬ 
doubtedly exceeds the gain. It would typically be more expen¬ 
sive to run a plant where the output constantly fluctuated 
between 60 per cent and 120 per cent of its normal capacity 
than to run steadily at about 90 per cent. Corroboration of this 

1 Ripley, Railroads: Rates and Regulation, p. 55. 


THE LAWS OF RETURN AND ECONOMY 


95 


is found in the fact that large combinations find it economical 
to concentrate the fluctuations in particular plants. 

The United States Sugar Refining Company concentrated its 
fluctuations in a large refinery in Brooklyn. 1 The Carnegie Steel 
Company has a huge by-product coke plant at Clairton, near 
Pittsburgh, which does not supply all the coke the company needs 
in active times, so that it can be kept running at full capacity, 
together with a fleet of towboats and barges which bring down 
coal from the company’s mines farther up the Monongahela 
River. The fluctuations are taken care of by beehive coke 
ovens located nearer the mines. Deplorable as it may seem that 
there should be any beehive ovens, it is certainly more economical, 
if they must be used at all, to use them in this way. This kind 
of economy seems to be one of the recognized advantages of 
horizontal combination. 2 

One way of expressing this fact is to say that machines thrive 
best and perform best under monotonously continuous operation. 
Their ideal would seem to be perfect regularity, but it does not 
follow that this is an economic ideal which human beings can 
safely adopt. If we could achieve it completely, we might be 
better working engines, but we should hardly be better men. 
Where irregularities can be taken care of by changing the pace 
or shifting to postponable work, they probably do no real harm, 
and may do some good, particularly to the men who are shifted 
from one job to another and so broaden their experience. Man, 
like any animal, works better when he is not required to hold a 
mechanically even pace through every minute of the day or 
every day of the year. But the kind of irregularity we now 
have goes a great deal farther than that modicum we need to 
keep us human, and almost any reduction that can be secured 
will be a much needed relief. 

Among the costs of irregular operation, besides those already 
mentioned, are the undue postponing of repairs, the increased 
turnover of labor, and the increased waste of materials due to the 
pressure of rush work. 

1 Jenks, The Trust Problem , 1911 ed., p. 35. 

2 Besides the passage from Jenks, already referred to, it is mentioned by 
Marshal] and Lyon, Our Economic Organization, p. 202. 


q6 


ECONOMICS OF OVERHEAD COSTS 


3. STANDARDIZATION 

Standardization is one of the most pervasive terms in the 
lexicon of business. There are standardized products, standard¬ 
ized machines, standardized processes, and the satirist of Main 
Street , Mr. Sinclair Lewis, is doing his best to convince us that 
business is producing standardized people. We are speaking here 
of standardized products. The purchaser does not want to 
be limited to standardized products, and the selling force which is 
in touch with the purchaser’s demand is under continual pres¬ 
sure to gratify some purchaser’s desire for a slight variation from 
standard in size or shape or in some minor feature of design. 

But the machine does not want to turn out a varied product. 
If it is making screws, it wants to run all day on one size of screw, 
because if it makes half a dozen or more different sizes in the 
course of a day, it will spend too much of its time being read¬ 
justed. The cost of adjusting it is a constant cost so far as con¬ 
cerns the number of screws it turns out before it has to be adjusted 
again. 1 Jenks quotes an estimate that the American Steel 
Hoop Company, by dividing up its eighty-five or ninety sizes 
and varieties so that each plant specialized in one group of 
products, was able to save from a dollar to a dollar and a half 
per ton, simply by avoiding the need of frequent changes of the 
rolls. 2 

Furthermore, when sizes and models multiply, storerooms 
become crowded. More goods have to be kept in stock to be 
equally sure of filling an order. Furthermore, special models 
are likely to remain in stock long after there has ceased to be a 
demand for them and the salesman who asked for them has for¬ 
gotten that they exist. For all these reasons, the production 
departments have decided that economy demanded a reduction 
in the number of sizes and models, often with startling results in 
the way of ridding the stockrooms of dead lumber. 

The result is a form of contest between the purchaser’s 
preference and the producer’s search for economical production. 

* See Redfield, The New Industrial Day, pp. 84-85, cited in Annals of the Ameri¬ 
can Academy of Political and Social Science, September, 1919, pp. 127-28. 

1 The Trust Problem , 1911 ed., p. 37. 


THE LAWS OF RETURN AND ECONOMY 


97 


If cost accounting methods were perfect, this contest would 
settle itself automatically, since the purchaser of a peculiar size 
or model would pay the full extra cost for which he was respon¬ 
sible, including the cost of interrupting other work. Apparently, 
concerns have not had the hardihood to fix prices on such work 
in proportion to its true differential cost. The outcome appears 
to be a tendency to divide producers into two kinds, those 
who make standard sizes and those who do a custom-order 
business. 

Standardization is related to size of plant and to horizontal 
combination in quite a definite fashion. Mechanical production 
in its simplest forms involves a high degree of standardization 
as compared to the handicraft methods that went before, and 
great increase in the size of the productive plant. The farther 
standardization proceeds, the more elaborate machinery it 
pays to introduce, and the heavier becomes the proportion of 
indirect costs. This tends to intensify competition, converting 
it into cut-throat warfare and thus strengthening the urge toward 
combination. 1 When a combination is formed they frequently 
find that they can gain economies by specializing their plants. The 
combination has an advantage over a number of independent 
plants, because it can offer a more complete “line” of goods and 
so mitigate or avoid the chief weakness of standardization; 
namely, its failure to gratify the consumers’ demand for a wide 
variety of goods. Thus if independent plants were to standard¬ 
ize, they would often be driven to combine in self-defense in 
order that their salesmen might “carry a full line.” 

It is worth noting, however, that there are other traditional 
savings of combination which hinge on not carrying specializa¬ 
tion of plants to its ultimate limits. If one type of goods is 
made by only one plant there are heavy freight bills to pay, which 
could be reduced if every order could be filled by the plant near¬ 
est the customer, thus “saving cross-freights.” Furthermore, 
fluctuations of output cannot be confined to one plant unless that 

1 See Homer Hoyt, “ Standardization and Its Relation to Industrial Concen¬ 
tration,” Annals of the American Academy of Political and Social Science , March, 
1919, p. 271. 


q8 


ECONOMICS OF OVERHEAD COSTS 


plant produces all types of goods. The dovetailing of different 
kinds of production in order to avoid the evils of seasonal opera¬ 
tion is another economy which can only be had by increasing, not 
reducing, the variety of goods turned out by one plant. Varied 
farming makes it possible to distribute the work of the farm 
more regularly through the seasons, and this represents a serious 
drawback to unduly standardized agriculture. Thus the prin¬ 
ciple of standardization, like all the principles we are studying, 
encounters opposing forces which set limits upon it. 

4. JOINT COST 

As has already been pointed out, true “joint cost” occurs 
where efficiency varies according to the proportion of different 
products turned out from one central process and where it is 
cheaper to turn them out together than separately. 1 There are 
two main types or stages of joint cost, in one of which the pro¬ 
portions are adjustable, as for example, adopting different kinds 
of crop rotations, or different breeds of sheep, some of which are 
better for wool while some are better for mutton. In the other 
type, the proportions cannot be adjusted except by leaving some 
useful material to go to waste, as for example, the proportion of 
hides to beef after the steer has been slaughtered. Petroleum 
products would seem to belong naturally in the second class, but 
under pressure of an insistent demand for more gasoline, the 
proportions have been altered, in part by merely shifting the 
limit of tolerance separating gasoline from the heavier and less 
volatile products, but partly also by new processes of “cracking” 
the heavier fuel-oil constituents of crude petroleum and so defi¬ 
nitely altering the molecular structure and increasing the available 
amount of light and volatile fuel. Here, as in the case of wool 
and mutton, and of crop rotation, the different products are in 
part complementary to each other and in part rivals. So far as 
the supply of gasoline is increased by refining more crude petro¬ 
leum, the more gasoline is made the more of the heavy oils will 
also be forthcoming. But so far as gasoline is increased by the 
“cracking” process, the more gasoline is extracted the less of 
the heavy oils remains. 

1 See chap, iii, sec. 15, above. 


THE LAWS OF RETURN AND ECONOMY 


99 


Now, so far as different products are rivals they lack one 
characteristic feature of joint products in the strict sense, because 
the increased production of one does not help to increase the 
production of the others, but rather sacrifices some of the others. 
But if, after the proportion of one product has been increased 
as much as possible, there still remains an irreducible minimum of 
the other available for working up, that minimum would have 
every characteristic of a joint product, for all its cost would be 
chargeable to the business as a whole. There would be no 
special or differential cost except the cost of working up this 
material and putting it on the market. If a breed of sheep is 
chosen with reference to mutton alone, and raised on the same 
principle, there still cannot help being some wool worth shearing, 
and this value is a clear joint product, and its cost is wholly a 
joint cost. 

To take a simplified illustration, if oats and alfalfa can be 
raised in rotation cheaper than separately, then the differential 
cost of oats, plus the differential cost of alfalfa, is less than the 
whole cost of the rotation, and there is a margin of joint cost 
which will be divided between the two crops in whatever pro¬ 
portions they can bear. If the rotation were actually to yield 
more oats per dollar expended than when oats were grown alone, 
the alfalfa could be given away without loss. 

On the other hand, when we have two possible rotations of 
oats and alfalfa in different proportions or varied rotations of 
different cereal, leguminous, and root crops, or when we are com¬ 
paring the old method of refining petroleum with a new process 
of “cracking” the heavy oils, the case takes on a new aspect. 
By the cracking process, for example, if it is practicable at all, 
the yield per $100 expended will be more gasoline and less heavy 
oil. 1 On this basis a sort of rate of exchange could be drawn up 
between gasoline and heavy oil. Then if the market price of 
gasoline, compared to the heavy oil, is higher than this produc¬ 
tion exchange ratio, it will pay to use the cracking process; if 
lower, it will not pay. In such cases, where there is a fairly 

1 The cracking process turns some kerosene into gasoline and some of the 
heavier oils into kerosene, so that the chief effect is as if heavy oil were turned to 
gasoline. 


IOO 


ECONOMICS OF OVERHEAD COSTS 


wide and elastic choice of methods, there does not appear to 
be any important element of expense that cannot be allocated. 
However, if the choice of available methods is narrowly limited, 
the separate cost of each product may be indeterminate between 
fairly wide limits, and a large part of the cost of the whole 
process may be “joint.” 

So far we have been speaking of those stages of the process 
where there is still a choice of methods. In the second stage of 
the process, after the crop has been planted or the oils cracked, 
there is no more elasticity. The price may go down until it 
reaches the direct cost of working up a given material rather than 
letting it go to waste. Anything above this makes it more profit¬ 
able to work it up than to throw it away, and contributes some¬ 
thing toward the common costs of the whole chain of processes. 
Here we have a case where a large part of the cost is not traceable, 
and must be apportioned on the basis of what the traffic will 
bear. 

As we have already seen, east-bound and west-bound traffic 
on railroads furnish another case of joint cost. They are essen¬ 
tially complementary and you cannot haul an added car east 
without being forced to haul it west again, empty if it cannot 
find some cargo. Every haul of an empty car represents a pos¬ 
sible joint product undeveloped. The special cost of west¬ 
bound tonnage is merely the excess cost of hauling cars full over 
hauling them empty, and the rest is joint. It is clear that a 
railroad may be in a good or bad position not merely in having 
an efficient plant or in having adequate or inadequate traffic 
for it, but also in having a balanced or unbalanced haul, and no 
matter what is the efficiency of the plant or the volume of traffic, 
the road will gain in efficiency if its east-bound and west-bound 
tonnage balance, and lose if they do not. 1 

The hours of day and night may give rise to a case of true 
joint cost because freight can move at the dead hours of night 
when passenger traffic drops to little or nothing. However, 

1 An exception might occur where east-bound tonnage requires a special type 
of car wholly unadapted to carrying the kinds of goods that move west bound, or 
where the cost, e.g., of cleaning the car and protecting the cargo is prohibitive. 
Ore cars must be carefully cleaned before they are allowed to carry coal, or else 
they will discolor the coal and reduce its selling value. 


THE LAWS OF RETURN AND ECONOMY 


IOI 


freight can also move in the daytime, and most roads have so 
much freight that a great deal of it has to move by day, so that 
the question becomes one of providing enough tonnage for the 
combined volume of freight and passengers. A more genuine 
issue is the seasonal cycle of traffic. A given yearly traffic 
could be handled with less plant and equipment if the road could 
dictate just how it should be divided among the different seasons. 
Additional off-season business costs far less than additional 
business in general. 

A clearer case is found in the public service industries. 
Residential lighting comes chiefly at certain hours of the day 
with its heaviest “peak” in the evening in winter. If current is 
to be used fairly regularly throughout the day it must be for 
power or other purposes than lighting. Thus the efficiency of 
an electrical power plant depends, among other things, on the 
proper proportion between two essentially different products, 
namely, residence lighting and power, or between current taken 
at ten in the morning and at five in the afternoon. Small 
plants or large gain equally by securing steady utilization. 
Here the investment is governed in the long run by the size of 
the “peak load”: the heaviest half-hour or so of demand which 
it has to stand ready to meet. 

Are freight and passengers joint products of a railroad? 
We have already seen that they are not, but it may be worth 
while to emphasize the fact by an illustration. If we have 
a number of parallel railroads serving a common traffic, such 
as the through traffic between New York and Chicago, would 
it be more efficient for each railroad to carry a given share of 
passengers and a given share of freight, or for one or two rail¬ 
roads to specialize in the passenger business and leave the 
freight for the rest to handle ? Does the taking on of an extra 
hundred thousand tons of freight contribute toward facilitating 
the taking on of extra passengers in the same way that killing 
an added hundred steers for the sake of the meat contributes 
toward the production of more hides and other by-products? 

Clearly it does not, but rather the contrary. The carrying 
of freight and passengers together on the same line is, of itself, 
an element of inefficiency, because of the different speeds at which 


102 


ECONOMICS OF OVERHEAD COSTS 


the different types of trains need to run and the separate terminals 
they require. This handicap can be minimized on a four-track 
road, but never disappears entirely. It would be more efficient, 
if it were practicable, to devote one line to passengers and other 
lines to freight. This was done to some extent during the federal 
administration of the railroads. The reason why it cannot 
become a general policy is simply that local communities must 
receive both kinds of service and have not traffic enough to make 
two railroads necessary or efficient. Specialization would be a 
gain, but it could be gotten only at the sacrifice of the advan¬ 
tages of size, which are much more important. 

Is there any connection between joint cost and the economies 
of large-scale production ? There is a very definite connection, 
which may be stated in this way. Materials for main products 
and by-products will be present, some in large amounts and 
some in small. If the business gradually grows in size, these 
different products will reach the scale necessary to standard 
efficiency at different times. Typically, some of the minor 
by-products will still be present in such small quantities that 
they cannot be economically worked up, while the main products 
are already being turned out on a large enough scale to make 
possible most of the economies that come from size. After the 
main products have achieved all the economies of size, minor 
products would still be working materially short of the point of 
maximum efficiency, and the whole plant would still tend to 
expand. Thus the economies of large production tend to push 
the size of a joint establishment much farther than they would 
if every process stood on its own feet: much farther than is 
needed for the sake of efficiency in the main products alone. To 
make the weak links stronger, the whole chain is magnified tenfold. 

Where the main product itself is turned out in small quantity, 
the minor materials would frequently have to be worked up on 
such a miniature scale and at such inordinate expense that it 
would not pay to utilize them at all. For this reason it is com¬ 
monly said that savings from utilizing by-products constitute 
one reason why large-scale production is cheaper than small. 
This is true, granted that there is some other and independent 
reason why large-scale production of by-products is more eco- 


THE LAWS OF RETURN AND ECONOMY 


103 


nomical than small, and then it simply means that the economies 
in the by-products reinforce those in the main processes. In 
some cases even a small business unit can get the important 
savings that come with joint production. Rotation of crops is 
a case of joint production, but it does not necessarily mean the 
growth of extremely large farming units. If that comes, it will 
come for a different reason. Nor is it a cause of cut-throat 
competition among farmers or of personal discriminations in 
their selling prices. 

If the demand for one crop in a rotation increases it will be 
possible to sell the crop at a higher price. If the result is to 
increase the acreage devoted to this entire rotation, it may in¬ 
crease the supply of the complementary crops and lower their 
price, so that an increase in the demand for one crop may lead 
to a lower price for the others. The prices of the different crops 
are dependent on the demand rather than on their separate costs 
of production, within certain limits, beyond which farmers 
would be led to alter their systems of rotation. This may in 
some cases create a fairly wide margin within which prices would 
not be governed by a separate cost of production for each differ¬ 
ent product. But this is not discrimination nor cut-throat 
competition, and requires no special measures of control. If 
there is cut-throat competition in farming, it is due to other 
causes. Even in manufacturing, joint production can in some 
cases be carried on by enterprises of moderate size in reasonable 
competition with each other, selling different kinds of products at 
different prices, but not discriminating arbitrarily between differ¬ 
ent customers, nor engaging in general cut-throat competition. 

In conclusion, it has not been possible to make an exhaustive 
study of the various laws of return. The next two chapters will 
take up at some length the economies due to increased size of 
plant and different forms of combination, and some of them 
will be more fully illustrated later in connection with railroads. 
However, enough has been said to show that these laws are dis¬ 
tinct, and also that they work together, reinforcing each other, 
all of them contributing to the tendency our business world is 
showing to expand into larger and larger interests, more and 
more intimately bound up with each other. 


I 


CHAPTER VI 

HOW AND WHY LARGE PLANTS BRING 

ECONOMY 

SUMMARY 

Motives to expansion versus economies resulting, 104—Basic economies of 
factory production, 105—The general law of mechanical improvements, 107 
Physical economics of large mechanical units, 113—Unused capacity of parts of a 
complex plant, 118—Knowledge as an overhead cost, 119—Further division of 
labor, 123—Reduction of risks by consolidation, 126—Economies in buying, 127— 
Economies in selling, 128—Advantages in financing, 131—Disadvantages of 
size, 131. 

I. MOTIVES TO EXPANSION VERSUS ECONOMIES 

RESULTING 

Perhaps one should ask two questions about these economies 
rather than one, namely: What were the impelling motives to 
the development of large plants, and what are the economies 
which result after large plants have been built ? Frequently the 
difference between the two would be merely the difference 
between gains expected and gains realized, but frequently also 
it would be something more than that. Business expands under 
pressure of the economies of full utilization of existing plants. 
Business men become accustomed to thinking of the value of 

added business in these terms, and continue pushing sales, until 

» 

a larger plant becomes necessary. The economies resulting from 
this increase may be nothing like as great as the previous econo¬ 
mies of fuller utilization; in fact, if the plant grows piecemeal 
without having been carefully planned to make such growth pos¬ 
sible, the result may be an increase rather than a decrease in 
costs. 1 

For example, we have seen that railroad men appear fre¬ 
quently to think of the cost of added traffic as very low, because 
a road can nearly always carry a little more without increasing 
the fixed plant and equipment or the “constant” operating 

1 See papers by H. H. Titsworth and Henry T. Noyes in Annals of American 
Academy of Political and Social Science, September, 1919, pp. 63-65, 68-69. 


104 



HOW AND WHY LARGE PLANTS BRING ECONOMY 


expenses. And they continue to think in these terms even at the 
moment when they are enlarging their plants to handle the grow¬ 
ing traffic and are getting little or no economies from the increase. 1 
To some extent it would be fair to say that the economies govern¬ 
ing traffic policy are chiefly those of increased utilization of the 
existing plant, while those that actually result are chiefly the 
long-run economies of increased plant, and that the latter 
are far smaller than the former, so that policies of increasing 
traffic are based partly on expected gains that cannot in the long 
run be realized. 

Especially is it true of large consolidations that the motives 
are likely to be different from the realized economies, for the 
motives include promoters’ profits and the gains of partial or 
complete monopoly. In the present chapter, however, we shall 
be dealing with the large single plant, reserving the subject of 
combination for the following chapter. 

2 . BASIC ECONOMIES OE FACTORY PRODUCTION 

It is one thing to increase the output of a business from almost 
nothing to moderate size, and another thing to increase further 
the output of a business that is already quite large. In general, 
different forces are at work in the two cases, or at least the impor¬ 
tant forces are different. An output so small as to be next to 
nothing is always wasteful to produce, and this is so obvious that 
we naturally take it for granted. Adam Smith explained the 
fundamental reason as well as it can be done when he explained 
the advantages of the division of labor and showed how it is 
“limited by the extent of the market.” Nobody can produce , 
anything efficiently until he becomes a specialist in producing it, 
and he cannot become a specialist until he can make it his chief 
business in life to turn out that one product. He can become 
still more efficient in some part of the job if he can concentrate 
his time on that, but in that case there must be enough goods 

turned out so that he can afford to devote his whole time to one 

* 

part of the process while other people are doing the same for other 
parts. 

* See concluding paragraph of chap, iv, above. 






io6 


ECONOMICS OF OVERHEAD COSTS 


A village has to grow to a certain size before it pays one man 
to spend all his time making shoes; but it requires a huge national 
market to make it worth while to divide shoe-making into one 
hundred and ten separate processes with specialists spending their 
whole time on each one. Pin-making in Adam Smith’s time was 
in an intermediate stage, for there were eighteen processes, but 
Smith found a factory employing only ten men. These men were 
already using, “machines,” but obviously not the automatic power- 
machines of the present day. In any case, however, the subdi¬ 
vision of labor so simplifies each man’s task that it can be done 
by a machine, and so makes the machine inevitable. Some 
machines have taken over whole crafts; crafts*of some difficulty 
and skill. The spinning-jenny did this, and the power-loom. 
But these were the great inventions of the brief heroic age of the 
industrial revolution, and the tribute of respect we still pay them 
is witness to the fact that such achievements were rare. 

The moment we pass from a tool to the simplest kind of a 
machine, we have a new servant who is even more of a specialist 
than the laborer and it takes a still larger output to make it worth 
while for us to devote this specialist to one particular kind of 
work. He has such a decisive advantage over the ordinary 
laborer that it may pay to use him even though we cannot keep 
him busy all of the time. He puts the strength of steel in place 
of the strength of the human tissues and multiplies the power of 
men’s muscles by the principle of the lever and the screw, or 
harnesses the fall of rivers or the push of expanding steam. His 
fingers are never unsteady and he always makes the same motion 
in the same way, no matter how many times he has to repeat it 
or how rapidly he works. He can do many kinds of things that 
are practically impossible for ordinary labor. In somewhat the 
same way chemical reactions will do things that cannot be done 
by mere mechanical force, but it always takes a certain amount of 
specialized apparatus to carry on the processes of industrial 
chemistry, and this is merely another sort of machinery. 

The machine can have a hundred hands, each equipped with 
precisely the tool for the next operation, so that it never has to 
lay tools down or pick them up. It has virtually unlimited 


HOW AND WHY LARGE PLANTS BRING ECONOMY 107 

strength and can force metal into a mold or die at a single blow, 
shaping it in a fraction of a second more accurately than a crafts¬ 
man could after long and painstaking effort. It can strike any 
number of blows at once without needing to look and take aim, 
and can do things in twenty or two hundred different places at 
once, all with absolute accuracy. It can work so fast the eye 
cannot follow the motion, and always with the same precision. 
It relieves man of the burden of moving his materials from one 
process to the next, and by feeding them to the worker it inci¬ 
dentally sets his pace for him with an inexorable insistence. 

When the machine takes over a process which a laborer used 
to perform, it still commonly requires a laborer to tend it, so that 
the outlay for this one process is not diminished, but rather con¬ 
siderably increased To make a saving, the output must be 
increased at least in proportion to this increase in cost, while the 
speed and tirelessness of the machine make it able to increase 
output vastly more than this. It might, for instance, cost as 
much as five men and be capable of doing the work of fifty 
But this would really mean more than a fifty-fold increase in out¬ 
put, because, as in Adam Smith’s small pin factory, some men 
performed two or three processes, putting only part of their time 
on each, while the greater overhead cost of the automatic machin¬ 
ery made such a part-time system too wasteful to be tolerated. 
Persons being indivisible, it is small wonder that the size of 
plants increased, and small wonder that Henry Adams sought 
the historical formula for the nineteenth century in a geometrical 
progression; man’s application of power doubling every decade. 

3. THE GENERAL LAW OF MECHANICAL IMPROVEMENTS 

The quantity and quality of equipment which it pays to instal 
depends on the amount of use that will be made of it. It may 
not pay for a settler to lay a water pipe to save carrying three pails 
of water a day from a spring a few hundred yards from his camp, 
If the camp grows to a tiny settlement, it may pay to lay some 
sort of a trough or pipe to save the carrying of one hundred or 
more pails of water every day, and if the little settlement grows 
into a town, it will pay to instal a reservoir with underground 


io8 


ECONOMICS OF OVERHEAD COSTS 


pipes and perhaps a pumping system. A pipe is a fixed expense 
and the work of carrying pails of water is a variable one, and the 
fixed expense is for an equipment which makes variable expenses 
unnecessary. This is the type of all labor-saving machinery and 
all enlargement or development of labor-saving equipment. The 
saving is measured by the cost of carrying each pail of water 
multiplied by the number of pails that have to be carried. If 
this amount bulks large, it would pay to instal a considerable 
equipment to avoid it, while if it is small, the equipment may be 
uneconomical. 

The general rule governing all such questions of policy may 
be put in this form. Most labor-saving devices of a mechanical 
sort call for an investment in some sort of machinery or equip¬ 
ment and by means of this investment the labor costs of operation 
can be reduced. In other words, it is an increase in “fixed costs” 
which is to be balanced against a saving in the direct cost of opera¬ 
tion which, for one given plant and within the limits of its 
capacity, vary roughly with the amount of output. There are 
three principal quantities which determine whether it pays to make 
the change or not. The cost of the fixed instalment may be large 
or small. The saving on every unit of output that can be turned 
out by its help may be large or small. And the number of units of 
output on which this saving is made may be large or small. 

If the invention is one that means a huge saving, it will pay 
to use it even if there is not enough business to keep it busy all 
the time or even a large fraction of the time, or to use it to any¬ 
thing near its full capacity. Some devices may involve such an 
extremely large saving that they come to be regarded as funda¬ 
mentally necessary to anything like efficient operation. The 
patterns of a foundry are an extreme case of a form of equipment 
which is so necessary that the foundry cannot do without it even 
though it is idle most of the time. The minimum plant of a 
single-track railway is a less extreme case. Other devices are so 
important and bring so big a saving that plants of moderate size 
instal them even though they can only be used to a fraction of 
their total capacity, although an extremely small plant might not 
find them absolutely necessary. Lastly there are devices that 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


109 


bring only a slight saving, and these devices will not generally pay 
to use at all unless they can be worked very nearly up to their full 
capacity. Such things are generally improvements on the quality 
or increases in the size of the working units of the more funda¬ 
mental machinery (for example, bigger cars or heavier rails), or 
subsidiary devices installed for the sake of various minor econo¬ 
mies, such as the saving that is gotten from a slight reduction 
of the ruling grade or of curves on a railroad. 

Whenever any equipment is working at less than its full capa¬ 
city, there is, of course, a loss in efficiency, or rather, the full effi¬ 
ciency has not yet been reached. But there are two kinds of 
saving gained in connection with most introductions of mechani¬ 
cal equipment. The first comes when the new device is intro¬ 
duced and begins working, generally short of its full capacity, 
and sometimes very far short. The second comes with such 
growth in output as enables this machinery to be used more nearly 
up to its full capacity. The second is the chief kind of saving we 
get a chance to see going on, in the case of the big fundamental 
and necessary kinds of equipment, such as the minimum outfit 
of roadbed, rails, and rolling stock for a railroad. The introduc¬ 
tion of this equipment can happen only once and the saving is so 
great that it pays for the investment, even on a small traffic. 
Before the recent revolution in prices, the cost of moving goods, 
by road, ranged from 15 to 30 cents per ton-mile, 1 and the average 
operating cost on railroads was about half a cent per ton-mile. 
Another three-tenths of a cent per ton-mile furnished, on the 
average, the return on the investment. Traffic might be so sparse 
that a railroad worked at only one-twenty-fifth of average (not 

1 From an investigation by the United States Department of Agriculture, 
published in 1907. Mr. Charles Whiting Baker estimated in 1919 that before the 
war the cost of hauling farm produce on country roads was 25 cents per ton-mile, 
while motor-truck costs ran from 12 to 25 cents {Engineering News Record, July 10, 
1919, pp. 52-53). These estimates presuppose good roads. Average costs today 
are probably nearly twice as great. The figures are supposed to cover interest on 
the carrier’s investment, but nothing for the highway. For the purpose in hand, 
there is no harm in comparing these costs with rail rates, even though they are not 
strictly comparable, remembering that a motor highway that will “stand up” under 
trucks requires an investment of $25,000 per mile and upward. Many early rail¬ 
ways cost less tha n this, though they could not be reproduced for that sum now. 


no 


ECONOMICS OF OVERHEAD COSTS 


maximum) efficiency and it would still be cheaper to move goods 
by rail than by wagon, and enough cheaper to pay for the invest¬ 
ment. Thus it paid to build railroads long before there was 
traffic enough to utilize their capacity efficiently, and there was a 
long period after the first construction when any increase in 
utilization was almost clear gain. 

Since traffic was so sparse at first, it did not pay to put in any 
equipment that was not absolutely necessary Trestles were of 
wood, ridges were crossed by switchbacks instead of by tunnels 
or deep cuts, grades were steep and “pusher engines” were used 
on the worst ones, or trains were cut in two and taken over in 
sections, and the general character of the early equipment was 
hit off in the phrase: “ two streaks of rust on a right-of-way.” As 
the traffic grew, it became economical to put in tunnels and cut 
down grades for the sake of the saving in operating expenses, 
though it might have been positively wasteful to do this at the 
very first. Thus the growth of traffic brought one sort of econ¬ 
omy in the increased utilization of the plant which was already 
installed and another sort of economy from the larger and better 
fixed plant which the larger traffic made it profitable to put into 
use. 

This adaptation of equipment to volume of business is a com¬ 
monplace in railroad construction. The weight of rails and 
smoothness of the track, the quality of the ballast and its up-keep, 
the steepness of grades and sharpness of curves, and the size of 
locomotives and cars, all depend upon the density of the traffic, 
that is, they do if the railroad is economically constructed. The 
Virginian Railroad might be cited as the exception that proves 
this particular rule. “The late H. H. Rogers, the promoter and 
owner, a wealthy financier with no experience in railroad matters, 
desired to have a coal carrying line far superior to any other in the 
land. ” J The result was a single track road with grades and curves 
well-nigh eliminated, but at a cost of about $176,000 per mile for 
road and equipment, 2 or nearly three times the average for all the 

1 Sakolski, American Railroad Economics , p. 99. 

2 Interstate Commerce Commission, Statistics of Railways. The figure is for 
1912, the year when rapid growth of investment ceased. 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


ill 


railroads of the country at that time. In 1910 the road com¬ 
menced serious operations as a carrier, and in the next three years 
failed to cover its fixed charges by more than three and a half 
million dollars, in spite of the fact that operating expenses ab¬ 
sorbed less than 64 cents of every dollar of earnings, leaving an 
unusually generous proportion to cover fixed charges. Bonds 
were reduced and with growing traffic the road showed a phe¬ 
nomenally low “ operating ratio.” A considerable surplus w T as 
accumulated, though dividends were not paid except in 1917, the 
last year before federal operation. 

The road has been noted for its low operating expenses, which 
absorbed only 50.75 per cent of gross earnings in the banner year 
of 1916, yet in that year the net earnings from rail operations were 
only 2.8 per cent on the cost of road and equipment, or less than 
half the average for the roads of the country. If by reason of the 
perfection of the plant, operating expenses had been reduced to 
zero, net earnings would still have been below the average per¬ 
centage on investment. 

This of itself is fairly convincing evidence of overinvestment. 
The same result is indicated by a priori considerations. Let us 
suppose that an increased investment in way and structures takes 
effect by enabling the same locomotives to haul larger trains, and 
thus increases the possible output, and let us suppose that the 
stage of diminishing return has not yet been reached (meaning, 
diminishing return with reference to the proportion of variable 
to constant factors in this case). The variable factors are chiefly 
way and structures and cars, and the expenses that go with them 
in the way of maintenance. The constant factors are locomo¬ 
tives, and the labor involved in “ conducting transportation.” 
Coal might be treated as constant, though there would actually 
be some increase in consumption. The road could then handle 
io per cent more traffic with the same outlay for locomotives and 
their maintenance, and for “conducting transportation,” and a 
10 per cent increase in “way and structures” and their main¬ 
tenance, and in cars. Common sense will testify that this is the 
most favorable possible assumption, especially as diminishing 
returns are the normal thing in all industrial combinations of 


112 


ECONOMICS OF OVERHEAD COSTS 


productive forces. 1 Now if the traffic did not increase, the same 
condition would take effect in enabling the existing traffic to be 
handled with io per cent fewer locomotives and io per cent less 
expense for “conducting transportation.” 2 In the case of the 
Virginian Railway, if the last io per cent of the expenditure on 
way and structures yielded this much service, it was still a losing 
investment. Taking conditions as they were in 1916, the chief 
items in the comparison would be an increase of probably about 
$360,000 in the annual burden for interest and taxes 3 and a saving 
of $179,214 in conducting transportation, plus a possible trifling 
saving in maintenance. Thus the gain might be a little more than 
half the cost, on the most favorable possible assumptions. 

The railroad with growing traffic—the typical railroad—is 
constantly figuring whether its business has or has not reached 
the point at which it will pay to add something to the “fixed” 
investment for the sake of a saving in the operating expenses; 
for example, to cut down the ruling grade, or to lay heavier rails 
and get more powerful locomotives. They have constantly 
before them two ways of handling the growth of their traffic. In 
one the “constant” expenses remain constant and the variable 
expenses grow with the traffic, and in the other the “constant” 
expenses grow but the variable expenses per ton mile shrink. At 
some point in the growth of traffic the cost by the two methods 
will be equal, and the differential cost of the added traffic will be 
the same, whichever way it is handled. Thus there are two 
reasons for increasing the fixed plant; the necessity of added 
capacity and the opportunity for added economy. Some in- 

1 The reader is referred to chapter iv above for the background of this bit of 
argument, remembering that this is a case of “p ro P ort k> n of adaptable factors.” 

8 This case is not wholly fanciful. The rehabilitation of the Western Mary¬ 
land from 1913 to 1916 shows an increase of trainload without much change in 
“conducting transportation” expense per train. Since the plant to start with was 
dangerously inadequate in spots and badly proportioned, one is justified in assum¬ 
ing that this was an unusually favorable opportunity to make added capital pro¬ 
ductive. See Railway Age Gazette, August 4, 1916, pp. 183 ff. 

3 The writer does not have at hand figures showing how the investment was 
divided between way and structures, cars and locomotives; hence this figure is to 
some extent conjectural, but there is no plausible hypothesis that would make it 
less than $300,000. 



HOW AND WHY LARGE PLANTS BRING ECONOMY 


T.13 

creases in plant are made necessary by growing traffic, others are 
made profitable, though they may not be necessary. 

To prove the importance of this latter class, one need only 
remember that, in general, capital per establishment is growing 
faster than value of output , hence the economies of large-scale 
production are not typically due to the fact that investment costs 
remain constant, but to the fact that increased investment 
reduces the “variable costs.” In public utilities, cost of plant 
does not grow nearly as fast as producing capacity, but operating 
expenses grow still less, so that the proportion of investment 
charges is heavier in the larger plants. 1 All these facts should 
suffice to prove that no set formula which divides the existing 
expense accounts into two classes labeled “constant” and “vari¬ 
able” can possibly be an accurate description of the long-run 
economies of increased business. 

4. PHYSICAL ECONOMIES OF LARGE MECHANICAL UNITS 

Very small machines are worked by man power, while larger 
ones use steam, electricity, or some other form of power. Very 
small pow r er units are too uneconomical to be worth using. The 
multitude of operations involved in housekeeping are of this 
small size, and while machinery has long been used to lighten the 
housewife’s labors it was necessarily muscle-power machinery, 
such as carpet-sweepers, until men learned to develop their power 
in a huge central electrical plant, and take a little bit of it at a 
time through a very small motor. A toy steam engine, even a 
fairly big one, is not worth using even for work that is within its 
power. The work of feeding it, adjusting it, and controlling it 
almost duplicates the work that would have to be done for a 
bigger engine, but only produces a tiny fraction of the power the 
bigger engine would create. 

In fact, the engineer could furnish more power with his own 
muscles. In the language that we have used before, the labor 
of tending an engine would be practically a constant expense if 
we were to increase its size from the proportions of a toy to those 

1 Paul M. Lincoln, in Proceedings , American Institute of Electrical Engineers , 
1913, pp. 1937, 1942-43* 



ECONOMICS OF OVERHEAD COSTS 


114 

of the small-sized engines one sometimes sees at work on pile 
drivers or construction work. A locomotive needs two men 
instead of one, plus oilers, wipers, and other specialists in various 
jobs connected with tending the engine. These latter specialists 
work about the roundhouse and take care of a considerable num¬ 
ber of engines. And so it goes; the ocean steamship employs a 
small army of stokers, oilers, wipers, and engineers. By this time 
labor has become a variable expense, in that any increase in size 
will call for more labor, though perhaps not quite in proportion 
to the power turned out. 

Besides economy of labor, there is often a purely mechanical 
economy in the working of the machine itself. The resistance 
or elasticity of an iron bar or truss increases faster than its weight. 1 
This represents perhaps the chief reason why it is possible to 
double the capacity of a container or the power of an engine with¬ 
out doubling its weight. 

Increasing the size of a mechanical unit, such as a barrel or 
a firebox or a boiler or a boiler-tube or a plow or the hull of a ship, 
may may not bring increased efficiency, although it very often 
does. Efficiency is a proportion between things you want and 
things you do not want, and some of these things are bound to 
increase faster than others, as the working units get bigger. If 
the shape remains the same as the size increases, some things will 
increase approximately with the first power of the dimension, 
some with the square and some with the cube. Surface area, 
weight, and cubical contents are three typical elements, area 
varying with the square of the dimension, contents with the cube 
of it, and weight usually somewhere between, because thickness 
of wall does not usually need to increase as fast as the other dimen¬ 
sions. There are exceptions, such as the great strength and solid¬ 
ity required in the lower stories of very tall buildings; still in 
general where the thing you want is cubical contents—and con- 

1 See Kotany, “A Theory of Profit and Interest,” Quarterly Journal of Eco¬ 
nomics , XXXVI, 413, 43 2- 33 - This appears to be true, provided the weight 
does not have to be borne, or the pressure resisted, at an increasing distance 
from the points of support. Also the limits of elasticity are one thing, and the dis¬ 
placement produced by a given force, within those limits, is another thing and 
behaves in a different way. 


HOW AND WHY LARGE PLANTS BRING ECONOMY 115 

tamers constitute an enormous class of mechanical units—there 
size brings economy. 1 This is especially true where anything is 
to be kept hot or cold, since radiating surface varies only as the 
square of the dimension, and the thickness required for insulation 
does not increase at all, with the result that there is greater 
economy here than in the strength-giving structure itself. If the 
height of a building is doubled without increasing the thickness of 
wall, it will not be as strong, but it will keep out the cold quite as 
well. 

On the other hand, there are such things as radiators, where 
the whole purpose of a heat-container is reversed, and efficiency 
lies in giving off as much heat as possible from a given amount of 
w T ater. The thinner the walls, consistent with strength, the 
better the heat is given off; the smaller the tubes, the thinner the 
walls can be and still hold their shape, and the more radiating 
surface there is per cubic foot of contents. Thus the unit of 
structure tends to be as small as possible instead of as large as 
possible, but (and here is a saving clause of much import) the 
machine, or system of units, does not, therefore, have to be small, 
because it can muster these small tubes into an army of any size , 
and use them in connection with other units where size does bring 
economy. 

For an instance of this general principle we have the tubular 
boiler, where what is wanted is maximum transfer of heat from 
fire to water and minimum loss from either to the air outside. 
Small tubes promote the first, end; large aggregates of them pro¬ 
mote the second. If a boiler were simply a hollow tank, its con¬ 
tents would increase faster than the radiating surface, but the 
heating surface would increase no faster. As it is, heating sur¬ 
face and contents both increase faster than radiating surface. 

To take another instance, the carrying capacity of a ship 
increases with the cube of its dimensions, while its resistance in 

1 This fact is mentioned by Kotany in the article cited above. He makes the 
principle universal, however, asserting that: “The larger the size of a tool, the 
smaller its cost per unit of capacity.” This is not always true of tools; it depends 
on the question “capacity for what ?” But it would be hard to find anyone habit¬ 
ually using a tool too large to be economical, for obvious reasons, illustrated in 
the case of the large-size plow. 


n6 


ECONOMICS OF OVERHEAD COSTS 


the water increases more nearly as the square, so that it takes 
less power per ton to push it through the water at the same speed, 
and it can carry more paying freight per ton of displacement 
on account of the saving in bulk and weight of engines and fuel. 
In general, losses by friction and other diversions of energy do 
not increase as fast as power. 1 Inaccuracies and surface rough¬ 
nesses in bearings and sliding surfaces become smaller in propor¬ 
tion to the size of the whole. Ball bearings or roller bearings can 
be more economically used, for the cost of a ball bearing does not 
increase in proportion to its size. 

But—to reiterate—there is no mechanical law which says that 
efficiency must inevitably grow if the bulk of every tool is blindly 
multiplied. There is a story of a man who thought of getting 
the economy of large-scale production in plowing, and built a 
plow three times as long, three times as wide, and three times as 
deep as the ordinary plow and harnessed six horses to pull it, 
instead of two. To his surprise, the plow refused to budge, and 
to his greater surprise it finally took fifty horses to move the 
refractory machine. In this case the resistance, which was the 
thing he did not want, increased faster than the surface area of 
earth plowed, which was the thing he did want. Furthermore, 
when he increased his power to overcome this resistance he multi¬ 
plied the number of his power units instead of their size, which 
eliminated all chance of saving there, and since his units were 
horses, the fifty could not pull together as well as. two. For there 
is a waste in numbers which sets limits on the economies of large- 
scale production, whenever it depends on getting horses, mules, 
men, or other animals to pull together. 

This story is none the less true, even if the incident be wholly 
fictitious. It does not mean that there is no economy to be had 
in large-scale plowing, but it does mean that this man made a bad 
choice of ways to get that economy. If he had multiplied the 
number of his plowshares instead of the size he would not have 
increased the resistance out of proportion to the area he plowed, 
and if he had used a tractor instead of fifty horses, he would not 
have been bothered by not being able to make them pull together. 

1 Kotany, op. cit., p. 433. 



HOW AND WHY LARGE PLANTS BRING ECONOMY 


117 

A gang-plow drawn by a tractor is a practicable bit of labor-saving 
machinery. 

Therefore, though there is no law which says that big mechani¬ 
cal units are invariably more efficient than small ones, there is a 
law of human choice by which we can select those particular 
forms of increase in which the thing we want increases faster than 
the thing we do not want, and reject the others. If we cannot 
get a gain by increasing the size of one kind of unit, we can merely 
multiply the number of these units, and generally we will still get 
a gain through the increased size or fuller utilization of some other 
unit that works along with them. We can multiply our plowshares 
and get economy in tractive power, or multiply the lathes in a 
shop and get economy through a larger central power plant. So 
long as this increased number of units can be harnessed together 
mechanically, there will be no difficulty in making them pull 
together, but if pulling together depends on human organization, 
we may reach the limit of profitable size through reaching the 
limit of our own organizing power. 

This is the chief limit on size, but it is chiefly a limit on large 
co-ordinated enterprises rather than on large mechanical units. 
There are some mechanical features which tend to limit the size 
of single units—chiefly the fact that repairs, breakdowns, and 
fluctuations of output can be more economically handled if there 
are several units, so that all the eggs are not in one basket. Then 
when one unit is idle the others will work at full capacity and with 
no loss of efficiency. This means that a plant will often make its 
boilers, dynamos, vats, or what not, smaller than the most econom¬ 
ical size, for the sake of the flexibility that goes with numbers. 
In such cases there is a further gain to be had by a plant whose 
size permits it to have units large enough for maximum efficiency 
and enough of them for flexibility besides. So this fact makes for 
larger aggregate plants as often as it makes for smaller unit ele¬ 
ments. 

The economy of multiple units is especially important in ^ 
‘‘continuous processes” of cooking or other chemical action 
where the forces of chemistry cannot be hurried nor worked over¬ 
time, so that changing the rate of output means stopping the pro- 



n8 ECONOMICS OF OVERHEAD COSTS 

cess altogether and starting it again. That is frequently a very 
expensive thing to do, especially in the case of a blast furnace. 
It is far more efficient to work four furnaces steadily than six 
furnaces two-thirds of the time. 

Another fact which sometimes limits size is the difficulty of 
exerting force over increasing distances. The telephone is a 
special case in which the number of possible connections to be 
provided for increases faster than the number of subscribers. 
In general, however, mechanical units reach their limit of size 
not because larger size would increase costs so much as because 
it would not decrease them materially, while flexibility would be 
sacrificed by having one unwieldy mammoth rather than more 
units of smaller size. 

5. UNUSED CAPACITY OF PARTS OF A COMPLEX PLANT 

It is seldom or never that every part of a plant is developing 
all the output that is reasonably in its power, even when the plant 
as a whole is “working to capacity.” 1 An unloading plant may 
have two bridges in order to insure against breakdown, though the 
work does not tax the capacity of one. The patterns of a foun¬ 
dry play largely a waiting role. In a small shop a lathe would be 
idle most of the time. A larger shop might keep the same lathe 
busier without needing another, though it would need more 
equipment of most kinds. By the time a large lathe is working 
to capacity there may be a crane bringing it its raw material and 
this may be idle a large part of the time. And so on indefinitely. 
The main line of a railroad seems practically always to have 
unused capacity, the limiting factors being the rolling stock and 
the ability of the terminals to feed cars on to the line with regular¬ 
ity and take them off the line and dispose of them promptly at 
their destination. Thus there are practically always some points 
of congestion in a plant, and other parts that do not need to be 
increased in order to handle additional business. 

1 This does not refer to the “law of diminishing return,” whereby some factors 
must work at relatively low efficiency if the complementary factors are to accom¬ 
plish their utmost. It refers rather to the “minimum dose,” before diminishing 
return sets in. The examples in the text indicate the kind of cases referred to. 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


119 

This represents unused capacity, and in general the larger the 
plant the smaller the percentage of this sort of waste is likely 
to be. This is not always true, however, where the smaller plant 
grows in a patchwork fashion. If the smaller plant was carefully 
designed for just the volume of business it was capable of han¬ 
dling, growth may increase the waste rather than diminish it. 
Thus Mr. H. H. Titsworth takes the position that a balanced 
plant should not be unbalanced by piecemeal expansion, but that 
expansion should wait until another balanced plant unit can be 
added, and Mr. H. T. Noyes emphasizes the care necessary in 
planning a plant so as to make expansion possible. 1 

6 . KNOWLEDGE AS AN OVERHEAD COST 

There is another sort of productive machinery that is not 
often spoken of in the same breath with lathes or freight-cars but 
which has to go along with them if they are to be live industrial 
capital instead of worthless junk. This other productive instru¬ 
ment consists of knowledge, information, and the results of all 
forms of industrial experimentation and research. Here we have 
an expense that comes nearer being genuinely constant than any 
other, in the sense of being independent of output. 

The reason why other “constant” expenses all vary is that 
the machines, or buildings, or material equipment of any other 
sort, on which the so-called “constant” outlays are made, can, 
after all, do only a limited amount of work and can be used up. 
Two trains cannot run in opposite directions on the same track 
at the same time and there is a limit to the number of trains which 
can run in the same direction on the same track in one day, while 
the rails wear out more or less in proportion to the number of 
trains passing over them, and the ballast has to be renewed more 
or less in proportion to the pounding of the traffic. But the 
knowledge of how to temper the rails, how to prevent transverse 
fissures, how best to treat the ties and how to anchor the rails 
and ties together, how to prevent accidents, organize train sched¬ 
ules, and keep the necessary accounts and records—this knowledge 
is not worn out or exhausted no matter how much use is made 


• Annals , LXXXV, 63-65, 68. 



120 


ECONOMICS OF OVERHEAD COSTS 


of it. It is only the material means: the labor, the steel, the 
wood, and the chemicals, that may be used up in the process of 
exploiting this knowledge. 

In a sense, knowledge is the only instrument of production 
that is not subject to diminishing returns. This means that an 
added output brings possibilities of economy in all those items of 
expenses that come under the headings of knowledge, information, 
and research. The same research department can serve a large 
plant about as well as a small one. Indeed, in technical matters 
where a law, once learned, is universal, one laboratory could 
serve the entire business of the country or of the world without 
any added expense so far as the mere getting of the results is con¬ 
cerned except to allow for local differences in materials. Also 
the service of communication would cost something and the 
results might not be useful in countries where the market requires 
different goods, or where different customs of workmanship or a 
local scarcity of capital make standardized mechanical methods 
impossible, Thus there might be limits on the value of the 
results, but there can be little question that knowledge is useful 
in proportion as it is widely distributed, and that there is a dis¬ 
tinct loss in keeping any useful bit of general technical informa¬ 
tion as the exclusive property of a single producer and yielding 
its results in the way of more economical production only to the 
limited output of a single establishment. 

The costs of intellectual equipment, then, are one of the big 
sources of economy in large-scale production. This applies not 
merely to chemical and mechanical research and inventions, but 
to the trade information gained by the management through 
various channels of its own, including its own selling force. It 
applies to the working out of any standardized system of doing 
things: for arranging machines on the floor of a shop, or show 
cases and stocks in a retail store, for the work of accounting, or 
for advertising and selling campaigns. The advantage of large- 
scale production in these matters sometimes becomes so impor¬ 
tant that a new branch of production is established, specializing 
in these particular services and selling them to a large number of 
business men. Specialists in advertising and in scientific manage- 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


121 


ment are examples of this sort of thing in private business, while 
the Harvard Bureau of Business Research has been working out 
standard systems of retail accounting, and the Federal Bureau of 
Mines and the Federal and State Departments of Agriculture 
have been contributing to industrial research from the side of 
government. 

This movement is extremely interesting and extremely signifi¬ 
cant. It works in the direction of making small-scale produc¬ 
tion or moderate-scale production more efficient than before by 
giving it the advantage of a centralized service in those depart¬ 
ments where small-scale production is most peculiarly wasteful. 
If something of this sort is not somehow accomplished, scientific 
knowledge gives the large-scale producer an advantage which 
the progress of science is continually increasing. Scientific 
management means one more step in this process, because it puts 
at a discount the ordinary traditional skill of the laborer (a form 
of industrial knowledge that the small-scale producer could get 
on equal terms with the large) and puts in its place standardized 
methods resulting from scientific experimenting, time studies, 
and the work of a “planning department.” It has taken the 
trade knowledge of the laborers, which used to be practically free 
to any employer, and overmatched it by the aid of these expen¬ 
sive standardizing studies which become virtually a part of the 
employer’s capital, yielding greater economies in proportion as 
they are used on a large scale. 

The ordinary work of buying and selling shows economies that 
really belong in this class of better utilization of knowledge. An 
order to buy goods is a matter of communication and it costs no 
more to send in a big order than a little one. This saving is not 
merely a question of stationery and stenographer’s hire but of the 
time spent in getting together data to make the judgments 
whether it is wise to buy goods at such a time and at such a price 
• or not. 

While size clearly brings a gain in utilization of knowledge, 
there are two ways in which it can be taken and the business man 
generally chooses, perhaps more or less unconsciously, to take a 
little of both. He could, if he chose, spend no more on informa- 


122 


ECONOMICS OF OVERHEAD COSTS 


tion than he did before and get larger returns, so that the cost per 
unit of output would be lessened. Or he could spend as much per 
unit of output as he did before and get far more perfect informa¬ 
tion. In practice, he generally compromises between these two 
policies and gets some gain of each sort, with no way of measuring 
accurately the point of greatest efficiency. From the community 
standpoint, it is probably best if the manager gives the benefit 
of the doubt to increased research, but that is a doubtful gain for 
humanity unless our knowledge of human needs and human rela¬ 
tions keeps pace with the changes which purely technical inven¬ 
tions bring about. 

In the past, industrial research has been dangerously one-sided 

ft has promoted technical “progress” which has resulted in 

profoundly altering the effects of industry on the mind and life of 

the worker, and the human relations involved As a result, old 

habits and customs in these realms have lost their value, and 

a bewildered groping has taken their place, which is strikingly in 

contrast with the incisive certainty shown in the mechanical 

* 

field. A form of social wealth of the intangible sort has largely 
lost its value: society’s intellectual overhead has suffered serious 
obsolescence from the very growth in effectiveness of the intel¬ 
lectual overhead embodied in industrial research. Some method 
of restoring a balance is necessary, not merely to social welfare 
but to the continued effectiveness of industry. Innovation in 
the technical and business sphere calls for adaptation in the 
human sphere, and unless the two maintain a fair balance, the 
results are necessarily painful. 

The economies in the use of knowledge are largely responsible 
for the savings that come with buying and selling goods in large 
quantities, and for some of the advantages that appear in the 
raising of capital. This fact of large-scale buying and selling is 
often spoken of as one of the explanations of the economies of 
large-scale production. But of course it does not explain the 
economies of size merely to say that they happen in this depart¬ 
ment. The advantage that the big concern gets may be merely 
an unfair advantage in bargaining power and not a true economy 
at all, but so far as it is a true economy and rests on being able 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


123 


to do the necessary productive work more efficiently, it depends 
very largely on economical use of market knowledge, and the 
time and trouble it takes to acquire it. In much the same way 
the personnel department and the legal department show econo¬ 
mies in the imponderable factors of production. All in all, this 
is one of the important classes of economies, and one where the 
decisive advantages of the large concern can be tempered by 
organizing effective industrial research on a co-operative or a 
public basis. This is something that must be done, and done 
well, if healthy competition is to be preserved. 

7. FURTHER DIVISION OF LABOR 

Even large concerns could introduce more specialization of 
labor, if they were still larger. Ac worth tells how the North 
Western Railway employed two men solely to make artificial 
limbs, and the Midland kept eight cats to catch the rats that tore 
the sacks in its warehouses. 1 Where the business is already fairly 
large, gains of this kind, in the actual work of production, are 
mostly either of moderate amount or else have to do with second¬ 
ary sorts of service. These the factory is not usually obliged 
to produce without its own walls. The North Western Railway 
could have bought artificial limbs from some concern which pro¬ 
duced them on a larger scale than two men were capable of, 
though the railroad’s two specialists probably turned out a more 
individualized product, and one better adapted to the special 
needs of railroad workers. 

In general, it is in the work of direction, rather than in the 
physical work of production, that the largest gains from subdivi¬ 
sion of labor come after fairly large size has already been reached. 
There are two main kinds of division of labor in management, 
cutting across each other. One separates the forming of policies, 
rules, and precedents from the gathering of data on which the 
decision is based, and from the following out of these policies and 
precedents in particular cases, and the other separates diflerent 
departments of work such as purchasing, selling, engineering, 

1 W. M. Acworth, The English Railways. Cited by Edgeworth, Econ. Jour., 
XXI, 347- 


124 


ECONOMICS OF OVERHEAD COSTS 


financing, etc. One brings the economies of delegated detail and 
routine, the other the economies of functional specialization. 
Each has its advantages; each can render notable services, and 
each has the defects of its qualities. 

The economies of delegated detail increase the capacity of the 
manager, and of the overhead expense he represents. They 
enable more output to benefit by a given decision, and the study 
or experience that went into the making of the decision, and by 
this means they also make it possible and profitable to put longer 
and more intensive study into the making of each decision. In 
fact, what has been said already about knowledge as an overhead 
cost applies to the making of decisions and precedents, those in¬ 
tangible productive instruments which it is the supreme task of 
management to furnish. If the managing staff of a large-scale 
plant were made up of the same men who would be managers un¬ 
der small-scale production, with, the difference that the best mind 
made the most basic decisions and the others executed or applied 
them, there would be a considerable increase in the efficiency of 
management, but no reduction in the cost, in terms of the percent¬ 
age of effort spent on management. The tendency is, however, to 
go farther and delegate the more routine tasks to people who would 
not be managers at all under small-scale production, sometimes 
to people who are not of the manager type, but are even better 
at gathering data or at carrying out policies they were not respon¬ 
sible for forming. 

This may degenerate into exploiting cheap labor and intrust¬ 
ing routine managerial work to those who are incompetent to 
understand the “why” of what they are doing, and hence unable 
properly to discriminate between case and case, and to handle 
the exceptions that are always arising. An intelligent and respon¬ 
sible subordinate may receive orders drafted by one who is really 
his inferior, following a prescribed formula, and the subordinate 
has some provocation for feeling that he is dealing with a 
rigid, rule-enforcing machine rather than with a human being 
possessed of judgment and discretion, on whom the reason 
of his case might make some impression. Things become mat¬ 
ters of routine which should not be thus petrified; emergencies 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


125 


are at the mercy of routineers; and there is danger of developing 
the attitude which avoids assuming responsibility and spends 
much of its time and energy in “ passing the buck/’ or in staving 
off the efforts of others to pass it. 

The finest fruit of this is the bureaucrat whose chief ambition 
is to become a safe channel for passing reports upward and 
instructions downward, unmodified by any act of his. Of the 
same school was the district freight agent (or the clerk in his 
office) who received an inquiry as to whether a mixed carload of 
specified goods came in a certain rate group, and in return referred 
the local agent to the same tariff through which he and the shipper 
had already searched in vain. After some correspondence he 
hazarded an opinion that the higher rate prevailed, but the local 
agent gave the shipper the benefit of the lower grouping, and 
the shipper was left wondering whether “a ferreting auditor may 
drag the item from a mildewed file and an outraged law depart¬ 
ment may come roaring after me for the difference involved, a 
matter of $i.60 per ton on the entire carload. ,?I This is an example 
of the working of that system of “ checks and balances ” which is 
partly the direct result of size, but largely also of the public regu¬ 
lation (a further “check and balance”) which size carries with it 
when it reaches the stage of monopoly power. 

Tendencies in this general direction are nowadays both insidi¬ 
ous and powerful. Therefore, if the savings from delegating 
managerial detail involve delegating no managerial discretion 
and demanding none of the managerial type of initiative on the 
part of the subordinate, they are a danger rather than a source of 
strength. If “economizing managerial ability” means getting 
on with a smaller percentage of it than before, it is well-nigh 
suicidal in the long run. 

The concern may “economize” in that way, if it is willing to 
take the consequences, but can industry as a whole do so ? This 
would mean either developing less than before of that grade of 
ability which can make decisions, or not using all that is developed, 
which would come to the same in the end. Either one would 

1 Winthrop Martin, “A Shipper Comments on Railroad Morale,” Railway 
Age, LXXIII, 929. 


126 


ECONOMICS OF OVERHEAD COSTS 


be equally preposterous as a goal toward which to direct a con¬ 
scious social policy. Society cannot save by employing less of 
this grade of ability, but rather by developing more. And what¬ 
ever is unavoidably necessary for society is good industrial policy. 
Management cannot afford to intrust executive work to those 
lacking executive ability, nor to delegate it in a way which 
deprives the managerial agent of all executive discretion and 
responsibility. 

As for departmental specialization, the advantages are obvi¬ 
ous. The chief disadvantage probably lies in the fact that a 
department comes to have goals of its own, records of expansion 
and workmanlike achievement, which may not adequately meas¬ 
ure their net contribution to the success of the whole enterprise. 
Witness the conflict between selling department and production 
department over the undue multiplication of sizes and models. 
These are merely suggestions, since a thorough study of manage¬ 
rial specialization would carry us too far afield. One of its chief 
advantages consists in fuller utilization of knowledge, and this 
has already been discussed. 

8 . REDUCTION OF RISKS BY CONSOLIDATION 

It is a commonplace that uncertainty becomes less for a large 
group than it is for any of the members of the group. 1 One man 
may or may not die; one house may or may not burn; but a 
thousand men or a thousand houses behave in a predictable way. 
One aspect of this has been given a special name by the public 
utility engineers. It is uncertain just when one consumer will use 
his power, but there is considerably less uncertainty as to the 
distribution of demand from a large group of similar consumers. 
This depends on the fact that their greatest individual demands 
do not all come at the same time and this is what the public 
utility people speak of as the “diversity factor.” 2 

This advantage of size appears in almost every department of 
a business. The large company can carry its own insurance in 

x This is mentioned by Marshall and Lyon, Our Economic Organization, 
pp. 256-58. 

3 The technical measure of this is the ratio between the maximum demand of 
an entire group and the sum of the individual maximums. 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


127 


some cases. Its repair forces may work more steadily, and so 
may other kinds of indirect labor, while its orders for goods are 
likely to come in with greater regularity. Two or three customers 
with large orders will not make such a great impression on the 
total volume of business. Stocks of goods can be smaller com¬ 
pared to volume of trade. 

After the main business has already made the largest gains 
in the matter of stability, side-lines and by-products may still be 
on an unstable footing owing to small size, and may have much 
to gain from further growth. This greater regularity is an advan¬ 
tage both in buying and in selling. It does not exempt the com¬ 
pany from the ups and downs of the business cycle, but it fre¬ 
quently helps them through minor crises or seasonal depressions 
in particular branches of their business, if they have numerous 
other branches not subject to the same disturbance or having a 
different seasonal rhythm. All these elements of lower cost 
and risk react also on the company’s financing, making it easier 
for them to raise funds on reasonable terms. Another element 
which may or may not strictly belong under this heading is the 
fact that the large concern is somewhat less liable to have its 
processes made obsolete by some competitor. 

9. ECONOMIES IN BUYING 

The savings in buying may roughly be divided into two kinds: 
savings resting on economies in productive efficiency, and advan¬ 
tages in bargaining power pure and simple, although the two are 
intimately related to each other. As we have seen, buying on a 
large scale economizes all the work involved in studying the 
market and investigating the qualities of the goods, as well as 
the routine work of putting in orders and filling them. It is 
both cheaper for the purchaser to give large orders and for the 
seller to receive them and fill them, and the purchaser may get 
the benefit of this in the shape of a lower price. And the large 
buyer commonly knows the markets better and the goods better 

On the other hand, a large purchaser may get more than this in 
the way of bargaining advantage. Just what bargaining advan¬ 
tage consists of is not always easy to say; part of it undoubtedly 


128 


ECONOMICS OF OVERHEAD COSTS 


\ 

consists of favoritism and prestige and part of “bluff.” Apart 
from this, however, the advantage of size rests largely on the fact 
that it is simply not possible for the large concern to burden 
responsible officials with the work of quoting special prices for 
every little consumer. Some small consumers might know the 
market as well as large consumers do and might be in a position 
to buy from a rival at a favorable price. They might have all 
these strategic advantages that a large customer could possibly 
have—only the concern will not quote a special price for them. 
They can realize on their bargaining advantages only by going 
elsewhere. The concern will lose one customer, but it will be 
getting the benefit of the law of averages on the small customers 
as a class. If they treat them all alike, they will lose only a small 
percentage of their total trade, because most of the small custom¬ 
ers are not intimately in touch with the market. On the other 
hand, when a large customer comes with the same weapons in his 
hands, the concern will think of him as an individual, not as a 
unit in a problem of averages, and will be more likely to figure 
as close to their differential costs as may be necessary, in order 
to secure his business. 

One way of putting it is to say that a large order will repay 
the cost of a separate decision as to price policy, while the same 
cost would be prohibitive for each one of a lot of small orders. 
But if the concern cuts the price to an entire class of customers in 
order to hold io per cent of them, it will sacrifice part of its earn¬ 
ings from the other 90 per cent. On the other hand, when the 
large customer comes and they lower their price to hold his busi¬ 
ness, they need not lower any one else’s price at the same time. 
He becomes a class by himself and the whole of him is at stake in 
the bargain that may be struck. 

Other advantages come in the shape of service. People will 
take more trouble for the large customer, and they may take more 
trouble over one order than it is worth, if there are other orders 
in prospeetc 

IO. ECONOMIES IN SELLING 

It is difficult to figure whether large-scale production has, on 
the whole, increased or decreased the costs of finding a market. 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


129 


There is little doubt, however, that it has made them a larger 
percentage of the whole, because it has reduced the bare cost of 
manufacture in such a revolutionary way. For this purpose costs 
of transportation are properly counted as part of the total burden 
involved in reaching a market. The modern large factory, selling 
over a nation-wide market, must not merely produce goods 
cheaper than the small local establishment, but enough cheaper 
to pay the freight rates and other transportation costs on its 
products, its raw materials, its implements, and many of its 
structures and often on the goods which its employees consume, 
and something for the cost involved in carrying its employees 
to and from their work, including the lost time of the employees 
themselves. Manufacturing concentrated in large cities is ac¬ 
countable for all these burdens of transportation, which add up 
to a surprisingly large amount. 

The ordinary superficial view ol this problem is quite mislead¬ 
ing, for it looks no farther than the freight rates paid on the fin¬ 
ished product, and when it finds that these are so low as to be 
almost negligible it concludes that transportation need hardly 
be considered as a burden. Needless to say, this is quite beside 
the mark. The total bill for freight (inland water and rail), 
express, and parcel-post carriage alone is not far from io per cent 
of the total national product. If the costs of carriage and dis¬ 
tribution for which large-scale manufacturing is responsible could 
be accurately determined and compared with the value produced 
by large-scale manufactures, the percentage would be far larger. 
It is quite probable that the accessory burdens of carriage and 
distribution would exceed the bare manufacturing cost, in these 
large-scale industries, but not without imputing some contro¬ 
versial items, for which responsibility could only be inferred and 
not definitely traced. Granting, however, that the cost of dis¬ 
tribution could be made to look this large, this would not neces¬ 
sarily condemn concentrated manufacturing, but merely serve to 
point out how its economies are not clear gain, but have to bear 
the burden of the expenses outside the shop. 

Aside from transportation, marketing over a great distance 
involves other elements of increased costs. Salesmen’s traveling 




130 


ECONOMICS OF OVERHEAD COSTS 


expenses are heavier, time is lost in correspondence, and local 
peculiarities are likely to be less perfectly provided for. Dealers 
far from the source of supplies must keep larger stocks, since they 
cannot replenish them as quickly in case of sudden need. All 
these are penalties of distance On the other hand, granted that 
a business is already marketing over a given area, increased size 
by way of more “intensive cultivation” of the market brings 
some important elements of economy/ Carload rates furnish a 
concrete instance, while the actual work of organizing and carry¬ 
ing on a large-scale selling campaign affords some general savings. 
Planning the campaign is itself an overhead outlay and the minor 
tactics of the individual salesman have something of the same 
element in them—often they are learned in a company school 
for salesmen. Moreover, once a wide market is gained it usually 
returns a steadier business under the law of averages. A salesman 
can commonly handle a variety of related goods more economi¬ 
cally than one specialty. It helps him to have a “good line.” 
If a plant is to furnish him with a varied output to sell, and still 
produce enough of each type of commodity to secure maximum 
efficiency, it must be a very large plant indeed. 

Besides the physical question of productive efficiency, there 
are strategic advantages of bargaining position and competitive 
maneuvering, which play a more significant part in the act of 
selling than anywhere else, even in buying. A wide market 
gives opportunities for meeting local competition while keeping 
prices up in other localities, or for concentrating selling efforts 
where they may be most needed at the moment. It undoubtedly 
widens the margin within which the concern can choose its own 
selling policy, making the compulsions of competition less insist¬ 
ent. One symptom of this is the fact that the average amount of 
unemployment in dull times is far greater for large businesses 
chan for small. 2 While this is presumably the result of many 
forces, it is safe to conclude that one cause is the greater freedom 

1 For this distinction between covering a wider field and more intensive cover¬ 
ing of the existing field, see L. D. H. Weld, American Economic Review Supplement, 
March, 1923. 

3 See W. I. King, Employment, Hours and Earnings, pp. 30-34. Referred to 
by W. C. Mitchell, American Economic Review Supplement, March, 1923 


HOW AND WHY LARGE PLANTS BRING ECONOMY 131 

the large concern feels to take the lead in maintaining prices, 
while the smaller business is driven to maintain production at 
whatever prices the market makes possible. This testifies to the 
power of the large concern more than to the wisdom with which 
it is exercised. 


11. ADVANTAGES IN FINANCING 

“To him that hath shall be given” is nowhere truer than in 
the financial field, where the better established the success of the 
concern, the lower interest charges it can command, reflecting 
the safety which the investment derives from all the advantages 
that have been discussed above. 1 Besides which it is undoubtedly 
true that the commodities a concern sells advertise its securities. 
Conservative people are more ready to invest in a concern they 
already know as a large and presumably a successful one than in 
some business of which they had never heard before they were 
invited to buy its securities. Furthermore, there is a genuine 
advantage in being able to find a market quotation on the finan¬ 
cial page of any newspaper. The net result of all these advan¬ 
tages is to create a something else, compounded of them all and 
yet psychologically distinct; something more than the mere sum 
of its constituents. This something is called “prestige.” It is 
one of the most subtle forms of intangible capital, and one of the 
important advantages of size. 

And here we may bring to an end this story of the advantages 
of size, not because the subject is exhausted, but because if we 
went farther we should be carried beyond the limited field of 
introductory generalization and into the limitless realm of par¬ 
ticular cases. It remains to notice a few of the factors that 
work in the other direction. 

12 . DISADVANTAGES OF SIZE 

The chief disadvantages of large size are summed up in com¬ 
plexity of organization, impersonal relations, divided responsi¬ 
bility, the multiplication of “checks and balances,” and the under¬ 
mining of initiative and spontaneous interest in the success of the 

T See Kotany, “A Theory of Profits and Interest,” Quarterly Journal of Eco¬ 
nomics , XXXVI, 413, 45 2 * 


132 


ECONOMICS OF OVERHEAD COSTS 


business. All these handicaps are matters which vary a great deal 
with the character of the w^ork. They are intensified where the 
size of the business results in its being put under special govern¬ 
ment control, and it is worth noting that they are all substan¬ 
tially the same weaknesses which handicap government operation 
as compared to old-fashioned “private enterprise.” In fact, 
large-scale production under modern conditions is rapidly nar¬ 
rowing the gap that separates private from public manage¬ 
ment. 

To take a sample illustration of the way in which these limi¬ 
tations work, farming is a kind of production in which either the 
worker must be vitally interested in the success of the undertaking 
or else must be constantly in touch with some boss who is vitally 
interested. He is not like a machine worker on a piece rate or on 
a job where the machine does its own driving. His work is varied 
and unstandardized and conditions differ so much that it is almost 
impossible to set a rigid task and hold a man to it without elastic 
personal supervision. Probably this is why the expansion of 
farm units by taking on large amounts of hired labor seems to 
bring decreasing efficiency rather quickly, except in cases where 
large areas of level land of fairly uniform quality are cultivated 
with one crop, using machinery on a large scale. Modern meth¬ 
ods of fruit-growing also involve considerable amounts of equip¬ 
ment and standardized operations, especially spraying. Here 
larger units appear to work well. In varied farming, however, 
the one-family farm appears to hold its own. 

The loosening of the ties that bind the organization together 
sometimes goes so far as to produce actual conflicts of interest 
and hostility. The company becomes an impersonal thing and 
the members and employees can steal from it without feeling that 
they are stealing from persons to whom they owe loyalty. This 
is largely the result of the corporate form of organization, but it 
increases with size and affects every class, from the board of direc¬ 
tors down to the lowest-paid manual laborer. In the case of 
labor, the large organization makes it harder to overcome the 
jealousy and suspicion and class hostility which lead laborers to 
feel that the employer is their natural enemy; that he does not 


HOW AND WHY LARGE PLANTS BRING ECONOMY 


133 


give the laborers what they are worth, and that it is the manly 
thing not to give him in return the best service of which they are 
capable. This disadvantage can perhaps be partly overcome by 
a really efficient personnel department, such as only a large con¬ 
cern could easily afford, but at present it cannot be said that the 
typical concern has demonstrated in its actions a belief that it 
can afford a really efficient personnel department. Many have 
dropped their personnel work when hard times made labor tract¬ 
able , 1 and others seem to have lacked the fortitude to keep a supe¬ 
rior man in this department after he had proved his worth. But 
perhaps this whole class of work is in too transitional a stage to 
justify predictions as to what size of concern will turn out, in the 
long run, to have the greatest advantages in this field. 

Being a member of an impersonal organization does not 
always injure the loyalty and effectiveness of a worker. At 
its best, the “traditions of the service” may establish a sort of 
personality behind the worker, mythical yet very real, which 
holds him up to his best performance and gives him the confidence 
and sense of support which serve to overcome the material dis¬ 
couragements of the lonely worker. In order to have this power 
for good, the service must itself have a character which can inspire 
loyalty by being worthy of loyalty. Modern business in its 
typical character as money-making does not easily inspire this 
kind of loyalty, except to some extent among the salaried 
employees. If it does actually succeed in establishing a real 
esprit de corps , it must be on account of the particular character 
of the particular business, and in the last analysis it must rest 
on some large and strong personality. The larger the business, 
the harder for this personality to make itself felt through the 
mechanism of orders and reports which are its ordinary means of 
communication. The morale of a service is a force which derives 
partly from the existing organization, but even more largely from 
its past. In fact, it is more a function of time than of mass, and 
quality counts far more than quantity. The business which 

1 See Douglas, “Personnel Problems and the Business Cycle,” Administration, 
July, 1922, pp. 15-24, especially pp. 21, 23, 24. 


134 


ECONOMICS OF OVERHEAD COSTS 


would build up this intangible asset cannot afford to strive solely 
or chiefly for quantitative expansion. 

Another phase of growth in size which m^y bring some dis¬ 
advantage appears when the growth is of the piecemeal sort and 
has not been adequately planned for in advance. In such cases, 
as we have seen, it may pay a concern not to try for expansion 
unless it can be fairly sure of finding a market for the product of 
an entirely new unit . 1 However, this sort of self-denial is a coun¬ 
sel of perfection and not likely often to be followed. Another 
way of meeting this difficulty consists of building a plant larger 
than the present demand requires, and accepting the handicap 
of working at a lower percentage of full capacity rather than the 
handicap of too frequent rebuildings and expansions. But this 
dose not mean that it is necessary either to wait until the market 
doubles in size before expanding or to build a plant twice the size 
required for the present output. A plant can be planned with 
reference to piecemeal expansion, generally at little extra cost, 
so that construction for a conjectural demand in the distant 
future is not economically necessary. Thus a concern need not 
build far ahead nor incur heavy additional expenses on this 
account. 


1 See p. 119, above. 


CHAPTER VII 

ECONOMIES OF COMBINATION 

SUMMARY 

The need of making distinctions, 135—Integration, 136—Horizontal combina¬ 
tion, 141—Freedom from competition, 142—Conclusion, 146. 

I. THE NEED OF MAKING DISTINCTIONS 

In dealing with this question it is necessary to distinguish at 
least three elements: vertical combination or integration, 
horizontal combination, and freedom from competition . 1 
Though in practice these are combined and interrelated, it is 
essential to conceive them as separate facts, if only for the purpose 
of studying their interrelations. If we ask, for instance, whether 
integration makes monoply inevitable, the first step is to study 
integration as a separate fact. In all these forms of combination 
the motives at work include a great deal more than the productive 
economies that are expected to result, while the expected econo¬ 
mies are often viewed in a distorted focus. 

The motives could roughly be analyzed into five groups. 
First come the profits of promotion, fortified by the “bias of 
happy exercise” on the part of men with a gift in that direction. 
Second, perhaps, comes the urge for increased power and wider 
areas of control, an urge which is so general and so strong that 
it seems fair to call it an end in itself. Third comes monoply 
advantage, complete or partial, or the extension of the range and 
effect of monopoly advantages already possessed. Fourth 
comes a reduction in the effectiveness of competing producers, 
which may be brought about either by absorbing the most 

1 Vertical combination means the combination under one management of 
successive stages in a chain of productive operations, such as mining, transporting, 
smelting, and rolling out rails. Horizontal combination means the combining 
of a number of separate enterprises in the same stage of production, such as a 
merger of sugar refineries. This does not refer to agreements limiting competition 
between independent concerns. Horizontal combination per se need not have 
monopoly either as its primary purpose or its inevitable result. 


135 



136 


ECONOMICS OF OVERHEAD COSTS 


efficient or by limiting the access of outsiders to materials, 
processes, or marketing facilities. To some extent this overlaps 
the gains of monopoly advantage, and to some extent it repre¬ 
sents the negative or “invidious” side of the fifth and last 
class of motives to combination Pnamely, gains in productive 
efficiency. 

These last are important, but not necessarily decisive by 
their own unaided force. They have more effect on the long-run 
success of combinations than on the original impulse to form 
them; they are a test of the fitness of combinations to survive 
far more than an explanation of their coming into being. In the 
earlier stages of a combination, the expected economies furnish 
“talking points” for the promoter, anxious to market his securi¬ 
ties and realize his organizer’s profits, and pretexts or “rationali¬ 
zations” for the hope of monopoly advantages or the urge of 
expansion and broadened control. 

From the standpoint of overhead costs it is the productive 
economies that are of interest, and from this point of view the 
preceding discussion is a digression. It is worth while, however, 
in order to avoid the misleading implications that would result 
from studying combination in terms of productive efficiency alone. 

2. INTEGRATION 

Integration is commonly thought of as a way of getting two 
'profits instead of one or of getting one’s materials “at cost.” 
This is, of course, true in that a business man expects to make 
more than the current rate of interest whenever he engages in 
a business for himself (even though this expectation may be 
frequently disappointed); and so he would naturally expect an 
outside venture to increase his profits. But this does not explain 
why he goes into the particular business of producing his own 
raw materials and tries to absorb that particular profit instead 
of doing what men of large property frequently do, invest in 
wholly unrelated industries. Perhaps he has a special feeling 
of dislike at having anybody else making a profit out of his own 
purchases. That is a natural sentiment, perhaps, but hardly 
an economic argument. It still does not explain why he should 





ECONOMIES OF COMBINATION 


137 


expect to profit more by doing his own carrying or mining or 
marketing than by going into some other outside venture. 

Perhaps he expects to succeed because his knowledge of his 
own business will help him to produce just the kinds of material 
which that business needs to use. Here we have a genuine 
economic argument—and also we have discovered an element 
of overhead cost. The employer’s knowledge of his own needs 
and of the conditions of his own business is an expensive industrial 
asset, and it can serve two purposes, contributing something to 
the needs of two businesses. In this sense integration is really 
a case of joint costs. This is perhaps a part, though not all, 
of the elemental truth expressed in Franklin’s proverb: “If you 
want a thing well done, do it yourself.” The other part is largely 
faithfulness: the servant not only understands completely the 
desires of the served but the sincerity of his service is beyond 
question. Both points are weakened where servant and served 
are huge corporations, acting via their hired employees; never¬ 
theless, both arguments still contain a deal of verity and force. 

Consequently another gain from integration arises, in the 
shape of great reliability in the supplying of materials. The 
two concerns adapt their processes to each other, and the supply 
of materials, both in quality and regularity, can be more carefully 
suited to the needs of the user than they would be if the two 
were independent concerns, no matter how genuinely the maker 
of the materials might be trying to look out for the interests of 
his customers. His attention would normally be scattered 
between a number of different purchasers and not wholly focused 
on the needs of one. Another thing that is saved is all the work 
of negotiation, bargaining, higgling, stimulating demand (on the 
part of the seller) testing qualities (on the part of the buyer), 
and much of the other work of buying and selling, which could 
be reduced to a matter of routine. Here we have an overhead 
outlay which is capable of being enormously reduced by vertical 
combination. 

Where a company makes its own equipment there is an 
opportunity to base policies of renewals, and especially the 
adoption of radically new types of machinery, on a truer reckon- 


138 ECONOMICS OF OVERHEAD COSTS 

ing of cost, because the constant costs of the equipment depart¬ 
ment can be treated as constant costs and are not converted into 
variable charges, as they are when the maker of equipment is 
independent and must cover his overhead out of the price he 
charges. If this opportunity is taken advantage of, it ought to 
have two results. Renewals and extensions should be scheduled 
with a view to regularizing the work, and minimizing idle over¬ 
head in the equipment department, rather than concentrating 
the work as is typically the case where the producer-customer has 
no responsibility for the overhead costs of the machine makers. 

And when some new type of equipment would call for new 
and specialized instruments to make it, an integrated concern 
should consider the policy as a whole, waiting until it is fairly 
sure that the machines-to-make-the-machines will be wanted 
long enough to justify them. This means looking a generation 
ahead. Then, having once made the decision, they would be 
slow to change, since they could continue without added over¬ 
head burdens, while change would involve a new overhead invest¬ 
ment. The non-integrated concern does not assume these risks 
but imposes them on the maker of machinery, and, therefore, 
has no adequate incentive to reduce them—wherefore it pays 
high, in the long run. This last point should not be over¬ 
emphasized, since much of the metal-working equipment used 
in making machines is quite adaptable. In some cases, however, 
a change in the product calls for large investments in new 
equipment. The regularizing of renewals and extensions is 
nevertheless an ever-present need and one of very great impor¬ 
tance. 

Integration may reach backward or forward, absorbing either 
the process of producing raw materials or the selling of the finished 
product, or both. Where it includes marketing, one of the most 
important gains lies in the fact that the dealer has so much more 
complete harmony of interest with the producer of the goods he 
is selling that he can be counted on to take proper care of them 
and to do them justice in the eye of the customer. It is said that 
one of the most important forces impelling the meat packers to 
take up marketing is the fact that independent dealers do not take 


ECONOMIES OF COMBINATION 


139 


good enough care to preserve perishable products . 1 Where goods 
have a specialty character, and have been much advertised, the 
manufacturer is often impelled into the marketing of them, in 
order to be sure they receive fair treatment and are competently 
pushed . 2 

Certain enabling conditions must be present. Sales must be 
large enough so that the concern’s interest in any locality will 
warrant establishing an agency there. Preferably, the manu¬ 
facturer himself should furnish a “full line” similar to the assort¬ 
ment of the ordinary dealer, but this is not absolutely necessary. 
Integration in marketing may either start with the manufacturer 
who reaches out into the field of distribution, or with the mercan¬ 
tile establishment which establishes its own factories. In either 
case the concern must have grown to very considerable size 
to make the extension worth while. Granted a large distributing 
agency, the gains from integrating it with factories are at bottom 
the same as when the process starts with the manufacturer. 
Even the moral element is there, since the dealer can now be 
surer of the quality of the goods he is pushing. 

Consumers’ co-operatives are a special case, for they often find 
difficulty in securing fair treatment from the existing regular 
dealers, who are interested in protecting their traditional place in 
the trade. The co-operative store is sometimes classed as a “ con¬ 
sumer,” and so is unable to buy goods at wholesale prices: some¬ 
times more indirect tactics are resorted to. It appears, in fact, 
that retailers, wholesalers, and manufacturers generally follow a 
“live and let live” system with regard to each other, and protect 
each other’s interests against outsiders who are regarded as 
interlopers because they threaten the conventional system of 
middlemen. This jealous attitude suggests a suspicion that 
possibly there are some customary margins of profit which could 
not easily stand the test of competition with more direct methods 
of selling: in fact, that there may be something like monopoly 
gains in some parts of the process, gains which an integrated 

X L. D. H. Weld, American Economic Review, March, 1921, p. 93. 

a On this whole subject see Haney, “Integration in Marketing,” American 
Economic Review, September, 1920, pp. 528-45. 


140 


ECONOMICS OF OVERHEAD COSTS 


concern could absorb into its own treasury. To the extent that 
this may be true, it justifies the man in the street in looking 
upon integration as a method of making two profits in place of 
one, or of saving the dealer’s profit on the goods. Such gains 
are unquestionably exaggerated in common report; nevertheless, 
one would be credulous who assumed that they had no existence 
at all. 

Integration has a connection with monopoly somewhat like 
the connection between joint-cost and large-scale production. 
Wherever one of a series of processes is in the hands of large 
combinations or of a monopoly, integration tends to spread this 
combination or monopoly through the other steps in the series. 
If one process is naturally monopolistic, the others tend to become 
so, if those who control the monopoly wish it. A monopoly 
in one stage can be used as a fulcrum from which to topple over 
competition in the other stages. Or, to change the figure, the 
chain of competition tends to be only as strong as its weakest 
link. The greater the advantages of integration, the harder to 
keep competition alive. 

Not all the forces are working in the direction of integration, 
however. Over against the maxim: “Do it yourself,” stands 
another, sponsored by economists from Adam Smith down. Its 
modern form is: “If you want a thing cheaply done, hire a 
specialist who does that thing for half the world and on a mam¬ 
moth scale.” This is the chief reason why any concern ever 
buys materials and equipment from other concerns and lets them 
make profits on the production and sale of these things. If my 
business takes but a small part of my neighbor’s product, he can 
probably do the thing more cheaply than I could, working as I 
must on a smaller scale. But may he not turn the argument 
around and make a gain by absorbing me? Sometimes, but 
not if his process is a minor or incidental one in my business. 
Thus we have the makers of parts for “assembled” automobiles, 
the advertising agency, the consulting engineer or efficiency 
expert, and the public accountant: functional specialists all 
of them, working on a large scale and more effectively than they 
could if confined to the service of one concern.. Such specialists 




ECONOMIES OF COMBINATION 


141 

are really the saviors of competition, for they give the concern 
of moderate size the benefit of services produced on a large scale, 
which the moderate-sized concern could not perform for itself 
without prohibitive cost. Without such possibilities, only huge 
consolidations could be efficient. 

It is significant that the examples are all but one concerned 
with some form or other of knowledge; the industrial instrument 
with unlimited capacity, which shows increasing economy with 
increasing utilization, and never reaches the stage of “ diminishing 
return.” To be efficient, the enterprise of extending the frontie' s 
of industrial and economic knowledge must be carried out on a 
large scale; yet the results must also be made available for the 
benefit of smaller scale producers, unless we are to submit to a 
ruinous waste of overhead in this respect. If industrial research 
becomes the sole perquisite of the concern which can afford an 
expensive laboratory, there is an end of economic freedom, and 
as a long-run result, perhaps, an end of economic efficiency, 
owing to bureaucratic stagnation. 

Even in the realm of knowledge there is a limit to the economy 
of size and combination. Research and publicity are best pro¬ 
moted, not by one all-powerful consolidation, free from all the 
checks and stimuli of healthy rivalry, but by a moderate number 
of strong organizations, able and ready to test each other’s work 
and to do it over again if necessary. Where results need veri¬ 
fying, repetition is not real duplication, and is far from being a 
waste. 

3. HORIZONTAL COMBINATION 

A large part of the savings of horizontal combination are 
simply continuations of those that come with growth of single 
plants. While the fundamental mechanical gains, and gains from 
subdivision of manual labor, are mostly confined within the walls 
of the plant, all the other sources of economy continue to yield 
some gains when plants in the same stage of production are 
combined with each other. Chief of these are the economies 
in the work of management, research, and information—the 
intellectual overhead costs. Similarly, the economies of buying, 
selling, and financing continue—the last possibly strengthened 


142 


ECONOMICS OF OVERHEAD COSTS 


by diminishing the menace of competition. As for the consoli¬ 
dating of risks, plants in different regions afford an obvious 
advantage in meeting local troubles of all sorts, from weather 
to labor disturbances. There is some possibility of further 
savings in connection with by-products, though this would be 
far easier if the whole output were within the inclosure of one 
plant. 

Beside these, there are some gains peculiar to horizontal 
combination. The saving of cross-freights and the specializing 
of plants 1 are always mentioned in this connection, though 
generally without calling attention to the fact that the same 
combination cannot get both savings at once, and that to the 
extent that it gets one it must sacrifice the other. Another gain, 
already mentioned in another connection , 2 comes from concen¬ 
trating fluctuations in a single plant. This involves some sacrifice 
of both the other economies, since the plant which carries the 
fluctuations must turn out a full line of goods and must sometimes 
ship to territory naturally tributary to other plants. 

There is also a chance, where plants are not so specialized 
as to differentiate them too much from each other, to compare 
records of efficiency between plants, and so to introduce the 
stimulus of rivalry without the drawbacks which result where 
each competitor keeps his methods to himself. This substitute 
for competition may have large future possibilities, but so far 
as it has yet been developed, it is doubtful whether it more than 
neutralizes the various elements of unwieldiness in an organization 
spread over such distances. 

4. FREEDOM FROM COMPETITION 

Freedom from competition has a good side and a bad side, 
from the point of view of efficient production. A benevolent 
genius, fired with zeal to utilize industry as a channel for helping 
his fellow-man, could perhaps do more effective work with a 
monopoly than under competition. Thus Gerald Stanley Lee, 
in his book Inspired Millionaires , addressing the man who wishes 
to make his wealth a force for good in the world, gives as his 

1 See chap, v, p. 97 above. 3 See chap, v, pp. 95-96 above. 


ECONOMIES OF COMBINATION 


143 


first piece of advice: “ Get a monopoly.” This is the prerequisite 
to being free from the ignoble compulsions of the market; free 
to give both laborers and the public what they need rather than 
what competition forces them to take. 

The moral is a doubtful one, however. If such a man were 
worthy of his mission, he could organize his industry so well 
that he need not fear competition, even if some of his missionary 
work involved an immediate sacrifice of commercial efficiency. 
If he could not make himself secure through efficient organization 
and performance, he would not be likely to mend his case by 
the tactics that are usually necessary in the process of getting a 
monopoly. For monopoly does not come ready-made; it has 
to be laboriously built up at the expense of a great many producers 
who want to remain independent. It must buy them out or 
force them out or make them willing to combine. There are 
ways of exerting such pressure, but they are not beautiful: such 
tactics are commonly of a sort that would furnish a poor back¬ 
ground for a mission of social uplift. And aside from this, they 
are quite inconveniently expensive. In fact, to gain and keep 
a monopoly position, and fortify it so that the monopolist could 
deliberately reduce his commercial efficiency and still prosper— 
to do all this would almost certainly involve heavier burdens 
than the wastes of competitive salesmanship, great as they are. 

These wastes of selling afford the chief opportunity for 
economy specifically traceable to getting rid of competition. 
The other savings often credited to monopoly are essentially econ¬ 
omies of size, or of horizontal or vertical combination. Monopoly 
as such means more than this, and less. It means less in the way 
of economies of size, because it may be merely an agreement 
or cartel in which many small producers retain their independence 
and their individual inefficiencies. It means more in the way 
of coercive control over possible competitors, for it is of the nature 
of monopoly that it must be able to keep them out by other means 
than superior efficiency in production. Otherwise it has no 
monopoly, merely a differential advantage in a field that is open 
to all comers. All these things are relative and shade into each 
other, but there is a clean-cut and wide separation between 


144 


ECONOMICS OF OVERHEAD COSTS 


the tactics which concentrate on achieving greater efficient 
than is possible to small concerns, and enjoying the benefit of 
the difference, and the very different tactics necessary to make 
a still larger profit or to be entirely independent of what possible 
competitors might do. These last are the tactics of monopoly 
as such. 

Monopoly as such, then, must be defined, not merely as a 
state of being, but in terms of the tactics necessary to establish 
that state of being and maintain it. So far as the state of being 
is concerned, it does not promote efficiency, but it does afford 
opportunities for it, in the field of selling. Under monopoly 
there could be a vast reduction of the competitive armies and 
armaments of billboards, circulars, traveling salesmen, and color- 
page advertisements, which, along with some real beauty, 
contributes so much to the ugliness of America, to the irrelevance 
of its landscapes, to limiting the ideals and ambitions of many 
clever artistic craftsmen, to the disappearance of our forests and 
the subsidizing of the more ephemeral levels of our literature— 
those which oftenest degenerate into the tawdry. Not all 
advertising could be saved. As has been urgently pointed out, 
some advertising is essential to large-scale production and the 
economies thereof, since the goods must find a wide market, or 
the large plant cannot be kept busy Nevertheless, the necessary 
minimum for this purpose is a very different thing from the 
amount made necessary by the competitive struggle to keep 
one’s own share of the large market or to get someone else’s 
share away from him. Monopoly could save largely here. 

Other economies, however, are slight or of doubtful character. 
Research does not gain by eliminating all duplication. Risks 
of competition are reduced, but in their stead appear the risks 
of public prosecution, and of the stagnation of improvement. 
On the other hand, there are serious elements of inefficiency 
involved in the attempt to gain control of the entire market, 
rather than to be content with a commanding position gained 
by limiting the combination to concerns of a high standard of 
efficiency. Inefficient concerns have a nuisance-value to a 
would-be monopolist which they would not have to a combination 



ECONOMIES OF COMBINATION 


145 

whose aim was to live and let live, and to get merely the benefits 
of size and superior efficiency. Weak producers must be 
absorbed, even though their plants prove useless and are closed 
down. This in turn may provoke the building of uesless plants 
as a form of industrial blackmail. The early history of the trust 
movement furnished glaring instances of combines overloading 
themselves with plants which were burdens rather than assets . 1 

More mature experience favors the live-and-let-live policy, 
though there is still a suspicion that patents are bought up for 
the purpose of putting them to sleep. Here, assuming the fact for 
purposes of analysis, we have overhead costs behaving strangely. 
A capital outlay is incurred, not to secure the aid of an instrument 
of production but to prevent it from being used, and from 
depreciating the value of existing processes by its competition. 
The act is essentially monopolistic, in that it involves control 
over the level of efficiency in the independent and supposedly 
competitive field of production. 

Would a concern ever put to sleep a patent on a more efficient 
process than the one the concern was using? Presumably not, 
if (i) the efficiency of the new process were known with absolute 
accuracy, and (2) the saving were enough to pay a fair return 
on the capital sacrifice involved in replacing existing equipment 
before its natural time. However, both these conditions offer 
a deal of latitude and uncertainty. Within this uncertain margin, 
the tendency of a secure monopoly is toward the conservative 
course, giving existing methods the benefit of the doubt, while 
that of the competing concern is toward taking some chances, 
since a stand-pat attitude is the most dangerous one a competing 
concern can follow. A monopoly owning a patent which is on 
the doubtful margin is very likely to let it slumber, though it 
might give a substantial sum to prevent someone else from devel¬ 
oping it. Even a patent known to be inferior may be worth 
buying and putting to sleep, if it is better than the run of processes 
used by competitors. 

All in all, it seems clear that in most cases monopoly, taken 
by itself, or monopolistic practices, or the attempt to establish 

1 Cf. Ripley, Trusts , Pools and Corporations, chaps, ix, x. 


146 


ECONOMICS OF OVERHEAD COSTS 


a monopoly, are all unfavorable to efficiency in the positive work 
of production. Monopoly makes some economies possible, 
but the getting of it and the maintaining of it is likely to involve 
burdens that outweigh the benefits. 

5. CONCLUSION 

From the foregoing discussion it appears that where single 
plants are large, the forces making for both vertical and horizontal 
combination are strong. Since large plants are the natural 
accompaniment of the use of large proportions of fixed capital, it 
follows that businesses of large fixed capital tend to develop both 
horizontal and vertical combination. We have also seen that 
vertical combination extends the possible range of monopoly 
control, while the connection between horizontal combination 
and monopoly is obvious. Added to this is the well-known fact 
that it is the industries of large overhead costs in which unre¬ 
strained competition develops the cut-throat character which 
w r ell-nigh forces the producers into some sort of combination, 
formal or informal, in order to avert disaster, or at least develop 
a standard of business practice which refrains from the tactics 
characteristic of unrestrained competition. It only remains to 
point out that where overhead costs are large, the risk of the 
initial investment is an obstacle to the free entry of new competi¬ 
tors, limits their possible number, and increases the risk that must 
be taken, with the result that the forces of “potential competi¬ 
tion” are easier to control. Thus large-scale production, com¬ 
bination, and monopoly or restricted competition are all more or 
less bound together, and all occur in the same class of industries. 

How great are the economies of combination? So far as 
horizontal combination goes, the most definite quantitative 
evidence is afforded by Dewing’s study of thirty-five combina¬ 
tions, all of which merged at least five concerns which had 
formerly competed, and all of which had had a ten-year history 
before 1914, when the disturbances due to the world-war made 
further comparisons irrelevant. 1 He finds that the promoters 

1 Dewing, A Statistical Study of the, Success of Consolidations . Mr. Dewing 
calls attention to the doubtful accuracy of the data on which this study had, per- 


ECONOMIES OF COMBINATION 


147 


of these combinations prophesied sufficient savings to increase 
their net earnings, on the average, about 43 per cent above their 
previous level. This average included only serious estimates, 
taking no account of what were obviously sheer exhibitions of 
rosy imagination. The outcome told another story, however, 
for the net earnings of the first year after consolidation averaged 
about 15 per cent less than the previous earnings of the constit¬ 
uent parts, while the result for the ten years following combina¬ 
tion was still worse; about 18 per cent less than the previous 
earnings of the constituent parts, without allowing for the fact 
that considerable amounts of new capital were invested during the 
ten-year period. Thus the ten-year earnings were only some 
57 per cent of the promoters’ estimates, while the bonds and 
preferred stock had been arranged so that fixed claims on income 
would absorb nearly half the estimated net revenues. Thus a 
heavy percentage of reorganization was virtually inevitable, 
when the savings of combination turned out to be a minus 
quality. 

Evidently, horizontal combination is not a guaranty of 
savings. It is at best an opportunity, and an opportunity non 
too easy to seize and exploit. Both in practice and in princh 
it is hard to disentagle its effects from those of partial monopl} 
Eliot Jones, in his recent book, The Trust Problem , x states that 
of all the successful trusts examined there is not one whose suc¬ 
cess cannot be explained on other grounds than those of the 
efficiency resulting from combination. 

It is fair to conclude that the chief forces making for horizontal 
combination are not the economies that result, but rather the 
natural urge to cease competing and combine. This is facilitated 
by the fact that increased size reduces the number of competitors 
and improved communication brings them closer together, with 

force, to be based. One probability is that the promoters exaggerated the previous 
earnings of the constituent concerns. Van Hise (Concentration and Control) 
presents a strong picture of the possible economies of combination, as implied 
in the wastes of competition, while Eliot Jones summarizes the actual achievements 
of the trusts in the unsparing fashion indicated in the following paragraph of the 
text. 


1 The Trust Problem , 1920, p. 539. 




148 ECONOMICS OF OVERHEAD COSTS 

the result that combination of some sort, close or loose, formal 
or informal, is very nearly a matter of “manifest destiny.” 
One modern observer has remarked that the telephone made the 
trust inevitable. 

Such combination, however, does not necessarily carry 
with it the essential powers of monopoly except within narrow 
limits. Monopoly power is a thing of many vicissitudes, and 
since it is hardly ever favorable to productive efficiency, its 
exercise in the cruder forms is likely to be short-lived. On the 
other hand, vertical combination appears to be on a firmer basis 
in certain varieties of work, while in others specialization is 
going farther and farther. 


CHAPTER VIII 

DIFFERENT KINDS OF BUSINESS RHYTHMS 

SUMMARY 

Examples of business rhythms, 149—Causes of business rhythms, 153— 
Methods of control or adaptation, 159—The financial motive to regularization, 
166—Other forms of motive, 169—Where regularization is impracticable, 171. * 

I. EXAMPLES OF BUSINESS RHYTHMS 

Every economic activity has some irregularities, some ups 
and downs; and these have a way of recurring regularly, or with 
sufficient approach to regularity so that one may discern an 
underlying cycle or rhythm. These patterns, cycles, or quasi¬ 
cycles are a fascinating as well as an important subject of study. 
What are their causes? How are they met? Do they mean 
waste or efficiency? So far as they represent inefficiency for 
the producers, what means can be adopted to improve the situa¬ 
tion, or is no improvement possible or desirable? Do the con¬ 
sumers demand irregularity, consciously or unconsciously ? Do 
those who demand it pay what it costs ? Would they demand itr 
if they had to pay what it costs ? Does anyone know what it 
costs? These and other questions arise and take varied and 
interesting forms in the different industries. 

If every industry is subject to this phenomenon, examples 
might seem superfluous: however, a number of concrete cases 
will serve to emphasize the pervasive character of periodicity 
in business, and the different kinds of periodicity that are found 
in different industries. 

One of the best recognized examples is the periodicity of the 
demand for electrical current for power and light. There is a 
very definite daily cycle and seasonal cycle, and the companies 
have taken definite measures to try to improve the distribution 
of demand, sometimes going so far as to change the character 
of the peak entirely, bringing it into a new time of the day. The 
demand for gas has a similar behavior, but in this case the 


149 


150 ECONOMICS OF OVERHEAD COSTS 

companies can dispose of the daily fluctuations by storing a 
day’s supply. The telephone and telegraph also have their own 
peaks of demand, and the night message is a familiar example 
of a policy aiming to utilize the slack time. The street railway 
also has its peak, and the suburban service of the railroads is 
affected in the same way. Different classes have their hours 
for travel and follow each other in waves—manual laborers, 
clerks, office workers, and, after a pause, the shoppers. Quite 
commonly there is an extreme concentration which results in 
enormous congestion, and yet if the company were to furnish 
enough trackage and cars to handle the “rush,” these facilities 
would be idle most of the time. That is, unless at the same time 
the concentration of demand could be reduced in some practicable 
fashion. 

Stores of different classes have their busy seasons and their 
busy hours of the day. Christmas and Easter are peculiarly 
active seasons, and also the periods just before customers leave 
the city for the summer holidays and just after they return. 
Mail-order houses have a weekly and a seasonal cycle to deal with : 
orders come in most heavily on Monday and there are also times 
when their customers are spending relatively little money, so 
that they find it worth while to conduct what are virtually special 
sales in such seasons. With theaters, the daily cycle is obvious, 
also the weekly and seasonal cycles. Hotels, resorts, and all 
places of amusement have their own peculiar rhythms. The 
city hotel has a different seasonal curve from the summer resort 
or the winter resort; and the city restaurant has a different 
problem from the automobilists’ resort. Sometimes it is pos¬ 
sible to eliminate most of the irregularity: sometimes a summer 
resort can be made into a successful winter resort also; but it is 
never possible to break up the habits of the people sufficiently 
to pull away as many vacationists in the winter as in the summer 
from the city as a whole. As a result resorts as a whole must 
still expect a long and relatively idle season. 

Navigation on inland waters and in northern latitudes gener¬ 
ally is another obvious case of periodicity, and so is the business 
of fishing, and of canning both fish and vegetables. Wherever 











DIFFERENT KINDS OF BUSINESS RHYTHMS 151 

the running of heating plants is on a large enough scale to occupy 
the full time of a worker, the irregularity in the demand for 
heating becomes important. Fortunately, in the nature of the 
case it fits in quite well with the closed season for navigation, 
so that stokers can frequently find work running heating plants 
when the inland waters are frozen. Coal mining, especially 
bituminous coal mining, is noticeably an irregular industry 
which gives employment for little more than two hundred days 
in the year, on an average. Since the demand for coal for heating 
is so definitely seasonal, perhaps the wonder is that mining is 
not even more irregular than it is. The natural antithesis to 
coal is ice, and many a dealer combines the two and improves 
his own percentage of usefulness thereby. The building trades 
are subject to the control of weather and the seasons, although 
less so than formerly, now that masonry and concrete can be 
laid even in freezing weather. Such things as the laying of 
sewers are done practically always at one time of the year, and 
few people would advocate trying to lay sewers in winter in order 
to secure a more even flow of employment. 

Sporting goods again have their definite times and seasons 
and the manufacture of clothing, millinery, and such things is also 
extremely erratic on account of the changes in seasonal require¬ 
ments combined with the uncertainties of style. Certain kinds 
of foods seem to be used principally at certain seasons: for 
instance, turkeys, while the “ Friday fish habit” is fairly well,,, 
established in many places where no one thinks of its origin. To a 
considerable extent, automobiles are also a seasonal product. 
Among the minor services, barber shops have a light business on 
Monday and a heavy one on Saturday while laundries are busiest 
in the first part of the week. This last is clearly a matter of 
custom which appears to have nothing back of it except the fact 
that the custom exists. 

One of the largest seasonal industries of all remains to be 
mentioned: namely, farming. Planting time and harvesting 
time create their special demands for labor, and the farmer who 
finds himself able to get hands for a short season does so, and 
comes to rely on doing so, while the volume of this seasonal 


152 


ECONOMICS OF OVERHEAD COSTS 


demand grows until it creates for the farmers an extremely 
troublesome problem, all because they have come to depend on 
such a difficult and fundamentally unreasonable method of getting 
labor. Fundamentally unreasonable, that is, unless it so happens 
that the rest of the industrial system can afford to turn loose the 
hundreds of thousands of workers whom the farmer needs, and 
can then re-absorb them without undue waste and uncertainty. 
Apparently, few people have seriously asked themselves if this is 
so; certainly not in the stage when the industry was fastening this 
habit upon itself. 1 Then there is the marketing of the farm 
crops and the transporting of them, which in turn is the largest 
single item in the seasonal cycle of the railroads. This last is an 
enormous and complicated cycle, differing for different commodi¬ 
ties and in different sections of the country. Then there is the 
farmers’ demand for fertilizer, seeds, farm implements, and 
machinery; all these are seasonal largely because farming itself 
is governed by the seasons. 

And on top of all these cycles of irregular production there 
is the thing we have come to call the “ business cycle,” which 
affects all industry in a way which cannot be predicted. If it 
could be exactly predicted it could largely be prevented and one 
of the reasons it persists is that, despite business barometries, 
no one can tell just how violent the swing will be or just when 
the turn is coming. Nevertheless, it follows in a general way a 
regular course of ups and downs. And industry has come to 
expect them, so that one of the chief subjects of business discus¬ 
sion is: In what stage of the cycle are we at the present moment ? 

From this list of examples it is clear that there are many 
different kinds of business fluctuations. Some of them appear 
to be quite inevitable, while others could be removed with very 
little trouble at any time it might seem worth while to remove 
them. Many of them involve serious waste of capital and labor, 
while about others there may be a considerable question whether 
there is any real waste involved. For a certain irregularity in 
doing things is characteristic of the human animal, and an 

X A recent article by Martha Bensley Bruere in the Survey (April i, 1923, 
pp. 7-13) is one of the few serious attempts to grapple with this problem which 
have come to the writer’s notice. 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


153 


absolutely rigid routine is not an efficient way to utilize his time 
and energy. So it will be worth while to look for a moment into 
the causes of these different kinds of cycles, dividing them, of 
course, into those that are daily, weekly, and seasonal and those 
which have a longer and more irregular period. 

2 . CAUSES OE BUSINESS RHYTHMS 

The obvious basis of the daily cycle is the fact that man 
sleeps at night, eats before he starts to work, moves somewhere 
to get to his work, eats again before he finishes the day’s work, 
and amuses himself after he is through. This means that under 
our system of division of labor, where some people are specialized 
to the job of carrying other people where they want to go, or 
amusing them when they want to be amused, many people’s 
work will necessarily come at inconvenient times, judged by the 
general standard. Conceivably, if the bulk of industry and 
commerce were content to be as irregular as is local transportation 
or the work of amusing the multitudes, it would be possible to 
smooth out the curves of demand for transportation, theater 
performances, and other subsidiary services. But there is a 
natural convenience about having different branches of industry 
and commerce running at the same time, so that they can 
communicate by telephone, and hence any revolutionary change 
would be unreasonable. However, an adjustment of fifteen 
minutes or half an hour is sometimes capable of doing a great 
deal toward relieving the peak of such a service as street-car 
travel. 

The weekly cycle is not quite so simple or inevitable as the 
daily one, but it rests chiefly on the Saturday half-holiday and 
the Sunday holiday and these should not be tampered with for 
mere industrial convenience. Here again, with our specialized 
system of transportation and amusement, some people have to 
work harder at those times of general recreation if others are 
to be given the facilities they demand for transportation and 
professionalized amusement. 

The seasonal cycle is still more varied in respect to the causes 
at work. Sometimes it is demand that fluctuates, like the 


154 


ECONOMICS OF OVERHEAD COSTS 


demand of the Christmas shopper, and sometimes it is supply, 
like the supply of fresh vegetables for the canneries, and there 
are derived demands, or demands for means of production, which 
fluctuate because of fluctuations in the productive activity they 
serve. Such, for example, is the demand for canning materials 
or for fertilizer and farm implements. Frequently the result is a 
joint effect of several causes, such as a combination of climate 
and custom. The climate is sufficient guaranty that people will 
not wear the same clothes in June as in March, but it is some¬ 
thing entirely different from climate which concentrates so much 
of the change on Easter Sunday, and it is something different 
from climate which makes the styles change from year to year, 
so that last April’s stock will be useless for next April. 

One of the forces at work rests on the fact that the flow of 
services people get out of their durable possessions is one thing and 
the work of supplying those commodities is a different thing, and 
this work of supply may be concentrated, although the demand 
for the benefits which the user receives may spread itself over the 
entire season or longer. Just because durable goods do not have 
to be bought at any particular time, it is possible for the buyers 
to concentrate their purchases, and there seems to be something 
imitative or gregarious about the human animal which tends to 
make him do so. Even business men tend to concentrate their 
business purchases without inquiring very deeply whether it 
would be better for industry in general (themselves included in 
the long run) to distribute them on some more scientific schedule. 
It is hard to say which is harder on the producer, to produce 
something which has to be consumed the instant it is produced— 
in which case the producer has to be working at just the time 
which other people find convenient for recreation—or to produce 
something which the consumer is then able to keep and enjoy 
as he pleases, for then the producer is employed only during the 
season—possibly a brief one—when all the consumers are furnish¬ 
ing themselves with this commodity; and while they go on 
enjoying it the capital and labor that produced it may be idle. 
Seasonal migrations are a case in point, because people stock up 
with many things before they move. 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


155 


It goes without saying that the effects of these different 
rhythms depend partly on their length and partly on their regu¬ 
larity and predictability. It makes a vital difference, also, 
whether you can predict not merely the time when the cycle 
will turn but also the particular land and quality of goods and 
services that will be wanted to satisfy the coming peak of the 
demand. In other words, if the commodity is standardized 
the producer can be making a stock of it in the off season. If 
it were not for this possibility of “making to stock” the Christmas 
demand for toys and other gifts would be nothing short of an 
industrial calamity and St. Nicholas would be a curse to mankind 
rather than a patron saint. Clearly, the shortest rhythms are 
the easiest to predict, partly because there is less time for funda¬ 
mental conditions to change from one peak to the next, and partly 
because it is possible to base one’s prediction on the observation 
of large numbers of cases. Also, the shortest cycles create the 
least economic and financial disturbance. As far as labor is 
concerned, since it must have its rest in any case, it becomes 
largely a matter of putting the hours of rest at an inconvenient 
time of day or putting the weekly holiday at an inconvienent 
time of the week. In many cases the actual result is to make 
people work seven days in the week, although this is never a 
real necessity no matter what is the rhythm of the industry, 
unless the establishment is very small. 

On the other hand, the seasonal cycles are long enough to 
involve what we call “unemployment,” both of capital and of 
labor, and of course the longer cycles are worse in this respect 
because no one knows just when to expect them. From the 
financial standpoint, the shorter cycles make no trouble at all, 
so long as they do not result in an inefficiency that cripples the 
entire industry. The quarterly dividend period covers its regular 
thirteen weeks, and any weekly cycle has no effect on the 
quarterly dividend. A seasonal cycle, however, may mean that 
a dividend will have to be paid at the end of a series of three 
lean months, in which case there is the financial problem of 
accumulating reserves in the more prosperous season to meet 
dividend requirements in the dull period. 


ECONOMICS OF OVERHEAD COSTS 


156 


When we come to the business cycle of several years’ duration 
this problem becomes more serious because the wait is longer 
and the recovery less certain. To a considerable extent, this 
lean period has to stand by itself, earning its own dividends if 
it can. Even if the concern lays by a surplus to carry it through 
the time of depression and then uses that surplus to pay dividends, 
the investing public will look on such a policy with more distrust 
than they would in the case of a regular seasonal industry which 
pays its dividend in the season of relatively low business but 
which can show that the business of that particular quarter bore 
such a relation to the usual earnings in that quarter as to promise 
satisfactory earnings for the whole year if the yearly cycle follows 
its usual shape. No railroad judges its prosperity by the 
earnings of the first three months of the year, because they are 
j normally lower than those of late summer and fall. What the 
railroad asks itself is whether the earnings in that period con¬ 
stitute that quarter’s usual share of a fair year’s earnings. 

To what extent do these irregularities constitute an evil ? 
They nearly always involve some idleness on the part of the 
fixed capital, and where this is a very large item it amounts to an 
economic waste large enough to be worth considering quite 
seriously. However, no one seriously mentions that we are 
wasting productive power on account of letting machinery lie 
idle through the hours of the night when human beings need to 
sleep, because there is a worse waste if people are forced into 
unnatural habits in their hours of work and rest. In the same 
way, it does more good than harm if the pace of the work varies, 
in moderation. Short periods of strenuous exertion or even of 
overtime, followed by intervals when the strain is relaxed and 
when the hours of work can be shortened or other provision 
can be made for recuperation—these are on the whole better 
than a mechanically even routine. 

However, as the wage system actually works, irregularities 
are not by any means handled in this beneficial way. Hands 
are laid off in the slack season and the result may be that those 
who are left work harder in order to make sure that they shall 
not lose their own jobs. Thus an added strain and worry is likely 



DIFFERENT KINDS OF BUSINESS RHYTHMS 


157 


to take the place of the relaxation that might otherwise be pos¬ 
sible . 1 Two things, then, are desirable. One is to reduce fluctu¬ 
ations, wherever possible, to such a moderate amount as can have 
the effect of relaxation rather than “ unemployment,” and 
another is to bring it about that fluctuations which might have 
this beneficial effect are actually so handled as to produce the 
best results possible in this respect, rather than leaving that 
matter to chance and the humanity of the employer. 

If all labor were on the same footing as the salaried members 
of the administrative staff, this question would settle itself. 
The labor would constitute an overhead expense to the industry 
and the employer would find it to his interest to prevent “idle 
overhead” so far as that might be practicable, while the irregulari¬ 
ties that could not be removed would not be the unmitigated 
evil which they too often are under existing conditions. How¬ 
ever, it is not immediately practicable to transfer all labor to such 
a status and it will probably never be desirable to try to make 
such a system universal. It would certainly not be desirable to 
compel an industry that only operates in summer to keep its 
employees idle through the winter or to compel each particular 
employer to find, by his own efforts, some business in which he 
himself can profitably employ them through the winter. Especi¬ 
ally if there are also other employers whose business only lasts 
through the winter, it would be extremely wasteful to force these 
latter to keep their employees through the summer or to find 
a summer occupation and go into it for the sake of keeping the 
employees busy. The more natural and obvious thing is for 
the employees to find their way from one employer to the other 
just as far as this is practicable without unreasonable risk and 
sacrifice to the employee. 

The responsibility which employers in such cases can be 
reasonably expected to assume is a responsibility for helping to 
furnish easy channels for this mobilization of labor which the 
peculiar character of their industry demands and by which they 

‘Henry R. Seager, in the Survey (XXXIII, 553), makes the point that a 
moderate irregularity of employment is labor’s only chance for an equivalent 
for the vacations of more favored workers, but that as things stand unemployment 
does not have this desirable effect. 


ECONOMICS OF OVERHEAD COSTS 


158 

profit. They make a saving out of not having to keep their 
labor through the entire year, but it is at the cost of a difficult, 
expensive, and imperfectly consummated mobilization of the 
labor force of the country. It costs money, consumes time, 
often interferes with family unity, and leaves a certain percentage 
chronically unabsorbed. It is reasonable, then, that the business 
should bear a part of the responsibility for this mobilization, 
and a part of the expense. An efficient labor clearing-house 
could cancel a great many of the seasonal demands against each 
other, but there would be a considerable remainder which could 
not be canceled, and for this remainder the seasonal industries are 
also responsible. 

They are responsible for making reasonable efforts to absorb 
it, at some sacrifice if necessary. And if there is an irreducible 
minimum of unemployment which cannot be absorbed it should, 
by some method, be converted and distributed so that it would 
take the shape of a reasonable slackening of the pace of work for 
many workers rather than total unemployment for an unfortunate 
minority. If industry needs them at the “peak” and for the 
sake of the peak business, then the peak should bear the responsi¬ 
bility properly traceable to it, and if it cannot properly bear it, 
there is a strong presumption that the peak needs whittling 
down. This may, then, be set up as an ideal and actual policies 
may be discussed and appraised according as they are or are not 
in harmony with this standard. 

In general, continuous employment of capital alone is not 
sufficient incentive to justify employing labor at unnatural 
times, especially at night. However, there are certain cases 
where the demand of the public is sufficient to justify night 
work for some employees or to make it virtually necessary. And 
in such a case, it is, of course, desirable that this night work 
should be as effectively utilized as possible: in other words, that 
the output at such times should come up to the reasonable capa¬ 
city of the force which has to be employed in any case. This is 
probably a sufficient justification for making low rates for night 
messages by telegraph and telephone, so long as the business does 
not get so heavy as to call for additional operators beyond the 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


159 


minimum that need to be on duty if the lines of communication 
are to be kept open at all. 

From what has been said, one pertinent conclusion may be 
drawn. It appears that the waste of idle capital is on the whole 
a desirable stimulus and guide toward removing unnecessary 
irregularities, but that it is not infallible. The effective utili¬ 
zation of labor power is more important. Where the attempt 
to utilize the full capacity of capital results also in the fuller 
utilization of labor it is, of course, a good thing and all that can 
be said about it is that while it works in the right direction it 
does not furnish a stimulus which is as large and powerful as the 
interest which society has in regularization. And in cases where 
the full utilization of capital requires a distribution of labor time 
which is undersirable for labor, either from the standpoint of 
welfare or lcng-run efficiency, then the labor consideration is 
virtually always paramount. 

3. METHODS OE CONTROL OR ADAPTATION 

We next come to the methods of controlling fluctuations 
of production, although some of these have already been suggested 
by what has just been said. So far as these cycles really involve 
waste, there are few, if any, which cannot be reached by some 
fairly adequate motives and methods, to improving them or 
to mitigate them. Such things as the daily cycle of work, food, 
recreation, and sleep will always take precedence over the con¬ 
venience of some of the workers. Where nature furnishes 
supplies of certain things at certain seasons only, there is often 
no way of postponing or distributing the work that is involved, 
and here the only thing to do is to dovetail it as far as possible 
with other work, or to treat it as a special load to be borne, not 
by the employees only, but by the industry which is responsible. 
Its responsibility should not end with the coming of the off season. 
The only other possibility is to utilize workers who do not have 
to earn their living the year round, but who are willing to take 
some supplementary earnings. Even this resource is a risky 
one for the peace and stability of the industry in the long run, 
in case such semi-independent workers come into serious com- 


i6o 


ECONOMICS OF OVERHEAD COSTS 


petition with others who are wholly dependent on their own 
earnings. 

If one were to make a list of methods of improving the regu¬ 
larity of production, they would probably fall into three main 
groups. One works through the broad strategy of commercial 
organization to dovetail together different kinds of work with 
different seasonal characteristics. Sometimes the employer, 
in a seasonal trade, may himself find a complementary line of 
business as, for instance, the dealer who handles both coal and 
ice. Sometimes another employer may be attracted into some 
complementary line of business, setting up an establishment in 
the place where the workers are. It would be hard, for example, 
for farmers to set up household industries on the farm, after the 
model of the old handicrafts, to keep their workers busy in the 
off times of farming. They could hardly compete with large 
factories. But it is possible for some minor industries which 
can work on a small scale and require little fixed capital to move 
out into rural regions where they can furnish an easy outlet for 
farm labor. Their own capital wall not be very well utilized; 
and they will suffer considerable idle overhead on this score, but 
if they can secure a cheap labor supply they may be compensated, 
and the benefit may be mutual. Now that farmers are organizing 
more and more, it would pay their organizations to investigate 
seriously the possibilities of this sort of dovetailing as a partial 
remedy for the problem of seasonal labor. In one farming village, 
for example, a small broom factory helps to fill in the winter 
months. 

More often, probably, the labor will have to move to the 
industry rather than the industry to the labor. This is a mobili¬ 
zation in which the individual worker is at a hopeless disadvan¬ 
tage in trying to guide his movements intelligently. It requires, 
as has been suggested, a national clearing-house in order to bring 
all the possible supplies and demands together. In some cases, 
this would need to have international affiliations, where there are 
industries with different seasonal rhythms on opposite sides of an 
international boundary. The establishment or maintenance of a 
system of this sort, as efficient as it can possibly be made, is 


DIFFERENT KINDS OF BUSINESS RHYTHMS 161 

essentially a proper charge upon industry. It could very fittingly 
be maintained by employers and laborers jointly. The only 
really adequate possible objection to such an institution would be 
in case the workers, for one reason or another, were unwilling to 
co-operate or to trust an institution supported by the employers. 
In that case it could not serve its purpose, but short of inability 
to serve its purpose no objections would be adequate. 

A second large class of policies consists of regularizing pro¬ 
duction without attempting to regularize the demand for the 
product, by simply storing the goods. Almost all factories do 
this to some extent: “working to stock” in slack seasons. The 
difficulties involved here are partly technical and partly com- 
merciaL The goods must be of a character such that they will 
be sure of an ultimate market, and the physical problems of 
storage must be met and overcome. In the case of clothing, 
for example, a concern generally has certain standard models 
which are made in large quantities, and the demand for these 
models can be counted on, so that they can be made in the off 
season. Blue serge suits in reasonably conservative styles are 
always safe to make. In the case of coal the problem is chiefly 
technical. Bituminous coal differs very much in its capacity 
to stand storage, and some kinds need to be stored under water. 
Also, if coal is to be stored without prohibitive expense, it must 
be done so as to avoid extra handlings; and this means storing it 
at the place where the dealer receives his coal from the railroad 
and loads it into his wagons for distribution, or in the stock pile 
of the industrial concern which consumes the coal. At the mines, 
coal is dumped from the mine car directly into the railroad car 
and storage at the mines would require an extra handling. 
Moreover, this would also mean that the railroads would have a 
more irregular coal movement than they have at present, because 
the coal would stay at the mines until needed for use, and thus 
most of the traffic in heating-coal would come at just the crop- 
moving time. Thus from the railroad standpoint the load factor 
would become worse rather than better. The question then 
becomes one of giving the dealers and large customers an ade¬ 
quate incentive to do their own storing in all cases where this 


j 62 


ECONOMICS OF OVERHEAD COSTS 


would increase the general efficiency of the business as a whole. 
This is a rather difficult problem and we shall come back to it later. 

Sometimes the natural resistances which any such change 
encounters can be overcome by enlisting the customer in a semi¬ 
co-operative method of handling the difficulty. Coal dealers 
sell coal cheaper in the spring, by way of giving the customer an 
incentive to do his own storing through the summer months. 
The efficacy of this depends fundamentally upon reasonable 
stability in the range of prices from year to year: otherwise the 
consumer can never be sure that he is really going to make a 
saving when he buys in the spring. The recent coal strike has 
probably created a bad break in the habit of buying ahead. 
One egg dealer has followed the policy of selling eggs during the 
cheap season for future delivery at any time during the next 
eight months, charging the current price plus a fee for storage, 
and thus giving the consumer the opportunity to take unto him¬ 
self the profits of the cold storage dealer, so far as these are 
speculative . 1 Policies like these involve interesting questions 
of consumers’ psychology and represent fines of experiment which 
ought to be more fully followed out. 

In the third place, there is a whole series of possible devices 
which are purely commercial, consisting of trying to find a market 
for the product of the off season. This may be done by cutting 
prices, by developing foreign trade, or the trade of some other 
separate market especially in the Southern Hemisphere where 
the seasons are the reverse of ours. Or sales may be pushed in 
other ways through the activities of the selling department. 
These tactics take effect in different ways. Sometimes it is a 
question of different classes of business or different uses of a 
commodity, having different natural rhythms, so that if they 
are harmoniously developed, the result will be greater regu¬ 
larity for the whole. Thus electric generating plants may 
strive to increase the use of current for power, because that will 
fill in the daylight hours when there is little demand for lighting. 
Or they may develop new household devices—washing-machines, 

1 See Paul Atkins, “Solving the Problem of Seasonal Goods,” Administration , 
October i, 1921. 


DIFFERENT KINDS OF BUSINESS RHYTHMS 163 

toasters, and vacuum cleaners—thus bringing into being a new 
demand with a better load curve than lighting. Or they may 
divide lighting customers into classes, theaters, residences, 
churches, etc., according as they have a better or a worse load 
distribution, so as to give lower rates to those classes which lay 
the least burden of idle capital on the central plant. 

Here, however, it becomes doubtful whether such concessions 
as these, made to whole classes, can have much effect in improving 
the general load curve. The number of theaters or the frequency 
of church sociables will hardly be vitally affected by a moderate 
readjustment of the light bill. Such differentials must be based 
not so much on the promotion of more economical utilization 
as on the idea of inherent justice, leaving utilization pretty much 
as it stands but penalizing those who are responsible for the most 
expensive varieties of use. 

In order to promote fuller utilization, where the proportion 
between different classes of use is fairly stable, it is necessary to 
reach the individual rather than the class, and to make it possible 
for any householder or theater-owner, if he improves the character 
of his own demand, to benefit thereby, without the need of being 
born again into a different class of users. There is a very impor¬ 
tant difference between policies aiming to improve the load by 
changing the proportions of different classes of business, and 
policies aiming to change the behavior of individual consumers 
within any given class by inducing them to improve the distri¬ 
bution of their demand. A still different class of policies are 
those based on abstract justice, without much likelihood of im¬ 
proving the load curve. 

For purposes of modifying the demand, the cutting of prices 
is the simplest solution, where it will work; but it generally 
needs to be accompanied by some propaganda in order to over¬ 
come the inertia of the consumers and educate them up to taking 
advantage of the opportunities offered. In general, one would 
expect that the individual consumer would need more persuasion 
than the business establishment, because business establishments 
are generally supposed to be on the lookout for the cheapest 
time and place to buy their supplies, whereas consumers are more 


164 


ECONOMICS OF OVERHEAD COSTS 


governed by habit. However, even business establishments do 
not seem to time their expenditures for the betterment of their 
permanent plants in such a fashion as to secure real long-run 
economy, though this is chiefly because the fluctuations that 
concern them most are the unpredictable movements of the 
business cycle. However that may be, a great deal has been 
done by making low rates for night messages by telegraph and 
long-distance telephone, for special uses of electrical current, 
for laundry work done in the last part of the week, and in other 
ways. Sometimes this means that new uses must be developed 
and sometimes it means that the consumer must simply be given 
a sufficient incentive to do his own storing. 

A moment’s consideration will show that the cutting of 
prices is more effective with some kinds of cycles than with others, 
and that it works differently with durable commodities and with 
perishable services. With durable commodities its effect rests 
not so much on stimulating increased demand or new uses as on 
inducing purchasers to time their purchases so as to create a 
regular flow rather than an irregular one. This may require 
the purchaser to store some of the goods for a time, and in such 
a case the maker has always the option of bearing the expense 
and risk of storage himself, in case the purchaser proves unre¬ 
sponsive to a reasonable stimulus. Thus the range of price- 
cutting is more limited in the case of durable commodities, and 
it is less likely to result in increasing the total demand. 

In this respect, the “business cycle” stands in a class by 
itself, distinct from all other kinds of industrial periodicity, 
partly because the lean years must furnish their own dividends, 
partly because the time and extent of recovery can never be 
anticipated with sufficient certainty to make it practicable as a 
general policy to “work to stock” and to store up goods in 
advance, and partly because the cycle lasts so long that styles 
will change and specifications alter, so that few goods are durable 
in the sense of holding their economic value through the changing 
phases of boom and depression. Thus the business cycle is one 
which is, in its very nature, almost impossible to treat as a cycle 
at all. Private business is almost compelled—almost, but not 


DIFFERENT KINDS OF BUSINESS RHYTHMS 165 

quite—to treat each phase of it as a condition standing by 

itselfc 

Because of the inherent uncertainties of the case, cutting of 
prices is often disappointing in its results. Instead of stimu¬ 
lating purchases, as it would if it were a reduction good on Mon¬ 
days only, or in February only, from a regular scale of prices with 
which the customer is familiar, it may merely lead him to wait 
for further reductions, and so, for the time being, have exactly 
the reverse effect from that which was intended. The lowering 
of prices could not permanently reduce the demand, of course, 
and in the end it could hardly fail to stimulate it, but the stimulus 
might not come until the reduction had lasted long enough to 
convince the market that bottom had been reached. And 
in the meantime, instead of concentrating, for instance, twenty 
days’ demand into fifteen days, the effect might be just the 
reverse. This appears to be one of the things that is meant by 
the phrase “spoiling the market ” 1 and it is in connection with 
the business cycle that this difficulty becomes acute. 

In some cases cutting of prices seems quite irrelevant: for 
instance, in attempting to mitigate the burden of the rush hours 
on a city street-car system. Here there is no need of lowering 
fares to make the passengers eager to travel when the crowd is 
more moderate. Their own comfort is sufficient inducement. 
But they are governed by the opening and closing times of the 
shops and offices where they work, and if any change is to be 
brought about it is the employers’ co-operation that must be 
sought, on a basis largely of general willingness to promote the 
efficiency of the whole economic system of the community in 
which they work. 

Thus the cutting of prices is a measure that will not fit every 
case. Often special selling activities are more effective, with or 
without a reduction in price. Seasonal “sales” have a large 
place here, though they also serve the slightly different function 
of clearing the decks of an unsold remainder of seasonal goods. 
Some concerns hold salesmen’s contests in the slack seasons; 

1 Cf. Taussig, “Is Market Price Determinate?,” Quarterly Journal of Eco 
nomics, XXV (May, 1921), 394, 396-97- 


166 


ECONOMICS OF OVERHEAD COSTS 


some stimulate off-peak business by demonstrating new uses of 
their goods (vacuum cleaners and electric toasters and washing- 
machines help to even the daily peak, while walnuts and cran¬ 
berries have been elevated from specialties for Christmas and 
Thanksgiving only to foods of general use). Mr. Paul Atkins, 
in an article from which many of the foregoing illustrations are 
drawn, tells how a group of automobile dealers bore the expense 
of plowing the snow out of the roads in their region, as a basis 
for a campaign to sell cars in winter . 1 When a summer resort 
undertakes to become a winter resort also, their chief problem 
is the development of a demand, rather than the reduction 
of prices. 

4. THE FINANCIAL MOTIVE TO REGULARIZATION 

These varied tactics have one essential feature in common. 
The establishment is willing to take off-peak business at a reduced 
price, or to spend an increased amount in storing, carrying, or 
selling the product, or in testing out and building up a scheme 
for dovetailing different products together, taking trouble and 
spending money which they would not otherwise spend. In 
every case there is a financial sacrifice incurred in order to improve 
the regularity of w r ork. Back of this must lie the realization 
that more regular work is w T orth a financial sacrifice, and this 
realization is the ultimate motive in the case, on w T hich the hope 
of effective action hinges. How adequate is this motive ? 

As a matter of impersonal and unmoral financial reckoning, 
it would seem that it pays to take off-peak business if that busi¬ 
ness is worth anything above the differential cost which it occa¬ 
sions to the concern. The question whether this fact furnishes 
an adequate motive depends mainly on three things. In the 
first place, it depends on the extent to which concerns know how 
large or how small their differential costs are. Cost-accounting 
systems do not show this, partly because they do not definitely 
set out to do so, being chiefly governed by other purposes and 
considerations, and partly because this information cannot be 
furnished, even approximately, without making departures from 

1 Paul Atkins, “Solving the Problem of Seasonal Goods,” Administration, 
October 1, 1921. 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


167 


the methods characteristic of accounting, taken by itself. On 
this subject we shall have more to say later . 1 In the second 
place, the outcome depends on the business mores: the prevailing 
ideas and ideals of good business. It depends on whether they 
do or do not approve of sacrificing the usual return above differ¬ 
ential cost, where necessary, in order to build up off-peak busi¬ 
ness. This in turn depends on so many factors that it deserves 
a separate discussion. 

Thirdly, the effectiveness of financial self-interest as a motive 
to regularizing production depends on how closely the differential 
costs borne by the employer correspond to the true differential 
costs of added production to the industrial community as a whole, 
and how closely the residual or constant costs of the employer 
correspond to the burdens which the industrial community must 
bear whether production is maintained or not. This also is a 
far-reaching question, and all that can be done here is to indi¬ 
cate briefly what effect different types of business rhythms have 
upon it. 

The willingness of business to recognize as sound practice 
whatever measures may be necessary to promote regularization 
depends partly upon keeping such concessions safely confined 
to off-peak business. For this purpose there is danger in the 
general principle that added business is worth taking at any 
price down to differential cost, because there may be an over¬ 
supply of productive capacity at the peak, so that the promotion 
of off-peak business would very easily degenerate into cut-throat 
competition and a general “spoiling of the market.” This 
difficulty is lessened if the peak is regular and the cycle short: 
having a daily or weekly period. Seasonal ups and downs are 
harder to distinguish from a general and permanent growth or 
decline of business, and the “business cycle” is still more so. 
Where reductions to stimulate off-peak business are confined to 
special markets, or to special uses of goods, there is obviously 
less danger of running on into general destructive competition. 
This is, of course, most clearly possible when the concern deals 
in services rather than in commodities which can be stored. 

* See chap, xi, below. 


ECONOMICS OF OVERHEAD COSTS 


168 


It may be that irregular output has resulted in such ineffi¬ 
ciency that there is considerably more labor and capital in the 
industry than would be needed to satisfy the demand if produc¬ 
tion were regularized, and in such cases regularization would be 
almost sure to precipitate destructive competition for a time, 
and to result in weeding out many producers and forcing many 
laborers out of the industry entirely. This would presumably 
be a salutary purge, from the long-run standpoint, but those in 
the industry would not naturally be inclined to invite it if existing 
conditions were tolerable: that is, if informal understandings 
and a general sentiment against “spoiling the market” were 
strong enough to maintain a living level of prices under the cus¬ 
tomary conditions of waste and inefficiency. Perhaps it would 
be invidious to cite the bituminous coal industry as an example, 
since that is merely an unusually conspicuous case. 

Under what conditions do the constant costs falling upon the 
employer furnish a fair index of the constant burdens borne by 
the industrial community as a whole ? In general, where there 
is so much fixed capital that maintenance, depreciation, interest, 
taxes, and insurance constitute a major part of the total expense, 
the employer’s expenses are very largely constant, and conse¬ 
quently this question largely takes care of itself. Where a 
large part of the wage bill is constant, the same thing is true, 
only the wage bill must be constant in such unmistakable 
fashion that it will be clearly recognized as such. For example, 
in a seasonal industry the wage bill will fluctuate with the volume 
of work done, and yet it may be that the industry as a whole 
has to pay for the idle time because the season’s earnings must 
be enough to attract the worker from other more regular trades. 
Obviously, no employer knows exactly whether this is true in 
his own industry, or just the extent to which it is true, conse¬ 
quently he does not know to what extent labor is a constant 
cost in his industry—meaning, in this case, a cost independent 
of the taking on of additional of-peak business. However, he 
knows that if he, alone, improved his load factor and afforded 
his employees io or 20 per cent more work in the year, he would 
probably still have to pay the same wages per hour or per piece 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


169 


as his competitors, In other words, labor might be a^ constant 
cost to the whole industry in the long run, under the general 
action of the laws of supply and demand, but this could only 
be determined by experiment, and in the meanwhile the experi¬ 
menter would find great difficulty in reaping the benefits of his 
innovation. 

This case presupposes that the labor is entirely or chiefly 
dependent on this particular industry for its support. If labor 
succeeds, on its own account, in dovetailing this employment 
with something else, then the situation is changed. An increase 
in off-peak business would not serve to fill up idle time but would 
have to bid against the alternative occupation. Added output 
“off the peak” would not be clear gain. Labor would not be 
a constant cost, even from the community point of view, and in 
such cases the employer’s expenses might be a fairly good index 
of the costs which the industry imposes on the community. 
Financial efficiency for the employer and collective efficiency 
for the nation at large might approximately coincide, in the 
matter of making sacrifices in order to build up off-peak business. 

These are but a few illustrations of the way in which par¬ 
ticular forces work. These forces, and others, combine in so 
many different ways that each case must be studied separately. 
However, such a general discussion as this may be useful by way 
of indicating what to look for in studying individual cases, and 
pointing out some elements that must always be taken into 
account. 


5. OTHER FORMS OF MOTIVE 

The motives to regularization are by no means confined to a 
calculation of differential costs: indeed, on the whole, they are 
oftener cast in a different mold. “Lessening labor turnover” 
and “keeping the organization together” are recognized as 
desirable and economical, and it is becoming customary to pay 
considerable attention to these matters. If this is done merely 
on selfish grounds, however, there is some danger that it may go 
out of style, wherever it involves a very appreciable burden, since 
the financial gain to the particular industry is a very uncertain 


170 ECONOMICS OF OVERHEAD COSTS 

quantity, and is in any case far less than the gain in efficiency 
to the community at large. Such motives need to have added 
to them—or better still, to be merged into—the broader force 
of a sense of responsibility for the industrial wastes resulting 
from irregularity, no matter what form these wastes take or 
upon whom the burden falls in the first instance. In the most 
general terms, one can say that the shortest and most predictable 
cycles—daily and weekly—are the ones in which the motives 
of private profit are most adequate to do whatever needs to be 
done by way of remedy, and that the longer movements—the 
rhythms of the seasons and still more the uncertain swings of the 
“ business cycle”—are the ones where a sense of obligation to 
promote efficiency is vitally necessary. 

So far we have been considering the question from the stand¬ 
point of reducing irregularity as nearly as possible to the point 
at which there is no essential waste of productive powers. To 
this end the situation calls for discrimination in prices, or an 
equivalent discrimination in profits through undertaking extra 
selling outlays, assuming the burden of storage or of side lines 
yielding less than usual profit, all in order to build up the use 
of idle time and capacity. These discriminations may be given 
to all the off-peak business, or to some section of it that is capable 
of special development if such a section can be made into a class 
by itself. 

On strictly logical grounds one might say that there is a 
presumption of waste if the off-peak business yields a material 
profit above differential cost, and if by using that profit as a sub¬ 
sidy to stimulate more off-peak business the load could be dis- 
distributed more evenly. That is a hard saying, and private 
business cannot be expected ever to follow it literally. Some 
sections of off-peak business may be virtually inelastic, and in 
such cases this rule would not apply, for there can be no waste 
in refusing to cut prices to develop business that would not 
develop even if prices were cut. Street-car travel is probably 
a case in point, for reasons already discussed. Discriminations 
by themselves would have little or no effect, and any very radical 
smoothing of the curve could only be had at the cost of dislo- 



DIFFERENT KINDS OF BUSINESS RHYTHMS 


171 

eating more important interests by disturbing the natural times 
of men’s comings and goings. Transportation is a servant to 
enable people to go where and when they please, not a master 
to dictate their movements according to the Iron Slave’s conven¬ 
ience. The same is true of the trades catering to the week-end 
holiday and the seasonal vacation with its migration to “resorts.” 
Whatever inconvenience and inefficiency may be involved must 
be reckoned as a penalty attached to professionalized amuse¬ 
ments, or to recreations which demand the help of any kind of 
economic services. 

6 . WHERE REGULARIZATION IS IMPRACTICABLE 

What of the cycles which are not to be molded into greater 
regularity by economic incentives, either because they cannot 
be changed or because change would be undesirable? Here 
three questions remain: adequate compensation to the factors 
of production, some offset for its necessary irregularity, and a 
just apportionment of the burdens among those who receive 
the benefits. As for capital and enterprise, the question of their 
compensation is not the most pressing issue arising out of these 
periodicities. So far as the shorter cycles are concerned, the re¬ 
wards of capital and enterprise are not disturbed. Hence only 
the longer ones need be considered, and even here the proverbial 
prudence and timidity of capital and the fact that enterprise 
specializes in the bearing of uncertainties are in themselves 
guaranties that considerable shrewdness will be expended in al¬ 
lowing for the rhythms of industry at least to the extent of guard¬ 
ing the average return to the enterprise. Against mere seasonal 
irregularities, this calculating foresight can be trusted to insure 
itself fairly well, but the business cycle is another story, and so 
large a story that it will have to be reserved for another chapter. 

As for labor, there are great dangers, partly arising from the 
newness of our modern economic rhythms and the slowness with 
which labor realizes what is happening to it, and its still greater 
slowness in taking steps to protect itself. The physical effect of 
any given daily load distribution, under modern industrial con¬ 
ditions, is a matter often requiring expert diagnosis to deter- 


172 


ECONOMICS OF OVERHEAD COSTS 


mine. The best of all load factors, for the machine, is that of a 
steel furnace, when it is working at all, for it works twenty-four 
hours a day. But this is a very bad load distribution for the 
labor, since some have to work at night, the usual system being 
for laborers to take turns on the night shift, changing from one 
shift to another in regular rotation at intervals of a week. This, 
however, means that when the change is made, one shift has to 
work a double turn without stopping. It means also that labor 
has to choose either an eight-hour or twelve-hour shift, with 
nothing in between; thus does the Iron Slave limit his nominal 
master’s freedom of choice. And the twelve-hour day, with 
twenty-four hours’ continuous duty at the time of changing 
from day shift to night shift, is one of the worst load schedules, if 
not the worst, to be found in industry. The old-fashioned Ameri¬ 
can lumberman’s work was irregular and the strain and hardships 
of the log drive shortened the working lives of those whom it 
did not kill or maim outright, but there were compensations not 
found on a twelve-hour shift in a steel-mill. These are merely 
conspicuous examples, cited largely to illustrate the lack of 
adequate knowledge of these matters. 

Where business rhythms are changing, labor inevitably suffers, 
and industry may suffer in consequence of labor overloaded at 
the peak and underpaid through the average of peak and dull 
times. The longer and more uncertain the rhythm, the more 
surely is the average competitive wage inadequate. Unorganized 
labor of low grade is nearly always in a position to be victimized 
by the unsteady job, while if organization brings power enough 
to resist, there is no guaranty that the resistance will stop at 
the point set by ideal justice, sweet reasonableness, or industrial 
efficiency. In the end labor may protect itself so thoroughly, 
through limiting the working day, as to deprive itself of the 
still more fundamental privilege of doing a fair day’s work for 
a fair day’s pay. But this is a large subject, and would lead us 
too far afield. Suffice it to say that wherever industrial rhythms 
are changing, or methods of production are changing so as to 
change the effect of a given rhythm on the worker’s physique and 
nervous system, the case clearly calls for careful study by the 


DIFFERENT KINDS OF BUSINESS RHYTHMS 


173 


industry as a whole, and a wage policy based on the requirements 
of long-run economic efficiency, rather than on what the mar¬ 
ket will afford for the moment. 

This does not involve any “violation of economic law” or 
departure from the type of recognized business practice, because, 
as we shall presently see, wages are not fixed on the principle 
of supply and demand, in the sense of making demand equal 
to supply at any and all states of the market and of the business 
cycle. They do not rise or fall as much as that would require. 
They are modified in the direction of a longer-run conception 
of supply and demand, colored by the conception of the “living 
wage.” What is needed is a more conscious recognition of the 
place of industrial rhythms in determining the wage which will 
in the long run bring forth the needed supply of industrial effi¬ 
ciency. Perhaps labor should help the employer build up the 
off-peak business by taking lower wages at such times ? Possibly, 
but this question must be left for later consideration. At the 
moment we are speaking of cases in which the hollows cannot be 
filled up, and in such cases a sacrifice of wages by labor would 
be useless. 

How about the consumer in such cases ? What does justice 
require in apportioning the price of the goods or services between 
buyers “on the peak” and off? It may seem strange that this 
argument has proceeded so far without once raising this question. 
However, we have been studying one kind of justice: that which 
looks to stimulating more and better utilization of the factors / 
of production, checking the growth of business that might swell 
costs, and promoting the growth of business that would reduce 
them. Apart from such actual effects, the question of justice 
between one consumer and another seems abstract, if not 
academic. It is the least important of all problems arising from 
the rhythms of business. If prices can have no effect on the shape 
of the cycle, there would seem to be no particular reason for 
discriminating between the business that is really responsible 
for the lion’s share of the capital charges and business which is 
responsible for none of them. For instance, the five-cent street¬ 
car fare—in cities where that convenient unit of charge still 


174 


ECONOMICS OF OVERHEAD COSTS 


prevails—is quite satisfactory as a basic rate and no departure 
from it would serve any useful purpose in improving the load- 
curve. So far as the promotion of efficient use is concerned, 
off-peak business can best be charged the same fare as rush-hour 
business. If any discriminations are made, they should be 
justified on other grounds, and if any serious attempt is made to 
improve the load curve, it must work through other methods and 
use other incentives. 


CHAPTER IX 


DIFFERENT COSTS FOR DIFFERENT PURPOSES: 
AN ILLUSTRATIVE PROBLEM 

SUMMARY 

The story of an imaginary plant, 175—Nine typical problems, 177—Different 
functionaries concerned with these problems, 180—The basic data, 183—First 
problem—to build or not to build, 186—Second problem—how large to build, 188— 
Third problem—a change of productive methods, 191—Fourth problem—income 
available for dividends, 192—Fifth and sixth problems—differential cost of added 
output, 194—Seventh problem—a temporary shut-down, 198—Eighth problem— 
a side line, 199—Ninth problem—abandonment, 200—Conclusion, 201. 

I. THE STORY OF AN IMAGINARY PLANT 

We may start with the general proposition that the 
terminology of costs is in a state of much confusion and that it is 
impossible to solve this confusion by discovering and adopting 
the one correct usage, because there is no one correct usage, 
usage being governed by the varying needs of varying business 
situations and problems, It is not even possible to settle the 
dispute as to whether interest is a cost of production or not, 
otherwise than by saying that it is a cost of a certain sort, which 
needs to be taken into account for certain purposes and not for 
others. In the same way “constant and variable costs” appear 
to mean different things for different purposes. This type of 
conclusion, beautiful as it may be in its tolerance, is nevertheless, 
by itself, formless and negative. The best way to give it positive 
meaning is to work through a series of different concrete situations 
and show in each case what cost means and why. 

For that purpose let us take an imaginary plant and follow 
it through its life-history in a simplified and abbreviated form, 
picturing a few of the typical problems which must be met by 
the management and whose solution will hinge on a correct 
knowledge of costs. We shall find, first and last, quite an 
array of questions and an equally varied assortment of answers, 
including what may be called the total economic cost of the 


175 


176 


ECONOMICS OF OVERHEAD COSTS 


enterprise, the financial expenses or outlays for which the concern 
is legally liable, the variable costs or differential costs involved 
in particular policies which the concern has the option of follow¬ 
ing, and the costs which are constant, or unaffected by a given 
policy. We shall find that costs which are constant with refer¬ 
ence to one policy may be variable with reference to another. 
Let us, then, state this series of problems, indicating what we 
would need to know in order to work out correct answers. We 
need not be bashful in calling for information, for our imaginary 
department of internal statistics and cost analysis is not subject 
to the limitations that hedge actual cost accountants, and can tell 
us anything we require to know about the cost of our business. 
In other words, we are seeking to study the true nature of costs, 
about which actual cost-accounting systems give only an approxi¬ 
mation. 

What is the use of this assumed omniscience, in view of the 
fact that cost accounting must deal in approximations and some¬ 
what arbitrary allocations of general items? The use is that 
such a study will shed a deal of light on the question whether 
the sort of approximations actually used in cost accounting are 
the most appropriate and useful for the purposes for which they 
are used. Perhaps one kind of approximations would come nearest 
that truth which is significant for one purpose, and another kind 
would be more accurate or more appropriate to the requirements 
of another purpose. We shall try to make our problem more 
real by assuming some of the more important data, doing our 
best to make them true in the sense of being typical, and then 
we can work out answers in dollars and cents to the questions 
proposed. 

Our answers will sometimes be different from those which 
a regular cost-accounting system would produce: indeed they 
will be different from those which any practicable cost-keeping 
system could possibly produce. This is done (to reiterate) 
in order to direct attention to the true nature of the goal at which 
the approximations of cost accounting ought to be aimed. One’s 
approximate estimate is likely to be a great deal better if it is 
at least aimed at the thing one really needs to know than if it 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


177 


is aimed at something else. Thus the chief use of this study 
may be to help us to see whether actual cost-accounting systems 
aim at the things a manager would need to know if he had omnis¬ 
cience at his disposal. If they do not, then increasing accuracy 
is no improvement. 

In order to make our supposed omniscience as reasonable as 
possible, we shall simplify the problem by making the plant 
turn out a homogeneous product. This eliminates the difficulty 
of tracing the costs of different grades or types of product, but 
leaves the problem of constant and variable outlays. Further¬ 
more, when output is homogeneous it is fair to assume that one 
unit costs as much as another, barring accidents, and the increased 
cost due to taking on additional business can be studied by 
watching how the total expenses behave. This is a much neg¬ 
lected device of analysis which can be used to fairly good effect, 
even where the output is quite varied in character. Though 
it could, of course, never be a substitute for cost accounting, 
it could always be a valuable supplement to it. 

2 . NINE TYPICAL PROBLEMS 

The problems we shall take up are the following: 

1. The plant is not yet built, and the problem is whether the 
building of a new plant is economically justified or not. The 
data include the probable selling price, probable volume of sales, 
and the whole economic sacrifice involved in raising the neces¬ 
sary capital and building and operating the plant. 

2. The plant is not yet built, and the problem is how large to 
build it. This involves chiefly the question what size of plant 
will produce goods at the lowest total economic sacrifice, together 
with the question whether the market will take the product 
without leaving too much idle capacity. The data are the same 
as before, but with separate estimates for different sizes of 
plant. 

3. The plant is built and in operation, and the problem is 
whether it is economical to change the methods of production. 
The data include any and all differences in the sacrifice involved 
for the ultimate owners of the business between the present 


178 


ECONOMICS OF OVERHEAD COSTS 


methods of productions and the proposed substitutes. This 
includes any sacrifice on account of additional capital re¬ 
quired. 

4. The plant is built and in operation, and the problem is: 
What income is available for dividends ? The decisive consider¬ 
ation here is the fact that dividends must not trench upon 
capital, and the data include all using-up of assets or incurring 
of liabilities, in the course of production. The corporation 
need not concern itself with the ultimate sacrifice of the individual 
investors; but merely with its own legal liabilities as a 
corporation. 

5. It is estimated that a reduced price will make possible 
increased sales, and the problem is how cheaply it will pay to 
sell goods. Starting with a given output, we have to find the 
cost attributable to a certain amount of additional business 
for purposes of deciding how cheaply we can afford to sell these 
additional goods. There is presumably some minimum limit; 
and below this minimum the concern will be poorer for having 
taken the additional business than it would have been it if had 
not taken it, while above this minimum the concern will be 
better off for selling goods than for not selling them. The data 
needed for an accurate decision include the total sacrifice of 
producing the larger supply of goods, the total sacrifice of pro¬ 
ducing the smaller, and the total difference between the two. 

We shall also need to know whether any reduction in price 
must apply to the entire output, or whether additional goods 
can be “dumped” in a new market or sold in some other fashion 
which will leave the existing business at existing prices unim¬ 
paired. In the latter case, any income above “differential cost” 
is clear gain, while in the former, the gain from the new business 
must be large enough to compensate for the loss involved in 
reducing prices on all the goods now sold. In practice, the actual 
condition is likely to be intermediate between these two cases, 
because it is generally possible to classify one’s business so as 
to give special reductions to certain classes, while at the same 
time it is impossible to avoid some leakage from one class into 
another. There are some other things which also make a differ¬ 
ence, as we shall presently see. 



DIFFERENT COSTS FOR DIFFERENT PURPOSES 


179 


6. Competition becomes increasingly keen and threatens to 
cut into the existing sales of the concern. The problem is how 
low the concern can afford to cut prices in order to hold its 
business. The only difference between this and the preceding 
question lies in the fact that the effect of a decrease of business 
is not quite the reverse of an increase, but for most purposes 
this difference would be negligible. 

7. A depression occurs, and the problem arises whether the 
plant should be shut down temporarily, pending revival. The 
data would include the value of any products that might be 
turned out, the cost of turning them out, and the costs that 
would have to be borne if the plant were shut down. This last 
involves loss of trade connections, the cost of rebuilding a dis¬ 
banded labor force, or the cost of retaining a nucleus of picked 
men through the shutdown and then of gathering a new force 
around them. Here we have imponderables which can only 
be roughly estimated, so that the actual decision may depend 
largely upon what is customary, or what is regarded as good 
policy in the long run for this business as a whole, or for the 
community at large. For that matter, the same could be said 
of the problems of price-cutting; the calculation of the financial 
interest of a business enterprise involves imponderables which 
are matters of judgment and are sufficiently indefinite to leave 
considerable margins within which the decision may be swayed 
by a mixture of custom, standards of sound business, the mob 
mind, and other forces of social psychology. 

8. It is proposed to develop a side line which can keep the 
plant and working force occupied during seasons when experience 
shows that the main product is in slack demand. The problem 
here is: What are the costs attributable to this side line for 
purposes of determining whether it is worth undertaking ? The 
data here should include, if possible, the whole economic sacrifice 
involved in producing the main product with the side line and 
without it, and the difference between the two. Lacking these 
data, we might be content with the costs on account of materials, 
labor, and capital directly devoted to the side line, minus such 
part of these burdens as would have to be borne in some form or 
other if the side line were not undertaken. 


180 ECONOMICS OF OVERHEAD COSTS 

9. Finally we come to the stage at which the question arises 
whether this plant is no longer needed, and should be permanently 
abandoned. Possibly the producers in this branch of business 
have installed more producing capacity than the market justifies 
and this plant, being no longer new, is feeling the pressure with 
peculiar force. The problem here is: after everything has been 
done which can be economically done to rehabilitate the efficiency 
of the plant, what are the minimum earnings necessary to justify 
keeping the plant in operation ? In other words, what are the 
costs attributable to keeping the plant going rather than abandon¬ 
ing it ? The question is like that of building a new plant, with 
one vital difference, namely, the plant is built and cannot be 
unbuilt without losing most of the investment. The capital 
sum that is really sacrificed by keeping the plant in operation 
is not the entire original investment but only the salvage value 
of the plant and equipment as it now stands. The difference 
between the original investment and the salvage value is a “ sunk” 
cost, a matter of historical interest but not affected by any 
subsequent acts of the management. 

3. DIFFERENT FUNCTIONARIES CHARGED WITH 

THESE PROBLEMS 

These nine problems are taken merely as types, and it goes 
without saying that they could be expanded and multiplied 
indefinitely. So far, we have not raised any of the questions 
of allocating costs as between different brands or classes of output. 
There will be goods of different sizes, patterns, and qualities; 
there may be some orders calling for special equipment and others 
which can be filled by the regular machines, with or without 
special adjustment. There will be large and small orders, or 
special designs for which a large or a small sale is to be expected. 

These are all problems of cost, in one sense or another, and 
their number and variety are truly surprising. It is worth 
noticing, too, that to a large extent these different problems have 
to be faced by different people, playing different roles in industry. 
For instance, the first problem, whether to build the plant or 
not, is that of the promoter and the investor, if the entire enter- 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 181 

prise is new, or a problem for a general council of the highest 
responsible authorities if it is an established enterprise which is 
thinking of building an additional plant. Also, as the reader 
need not be told, this problem dominates the economists’ notion 
of cost of production in the general sense: the entire financial 
sacrifice involved in entering upon a given venture rather than 
keeping one’s labor and capital wholly out of it. 

The second problem, that of large-scale or small-scale 
production, must needs come before the same supreme authorities 
for settlement, but for their specific data they will call in one 
special functionary, the engineer, whose peculiar duty it is to 
prepare advance estimates of the cost of constructing and operat¬ 
ing a plant, and to compare the cost and efficiency of different 
types of plant. Such estimates should be checked, of course, 
by the judgment of experienced operating men and possibly 
others. The engineer may have something to say, also, about 
the third question, that of adopting new processes or new types 
of equipment after the plant is in operation. Where the change 
under consideration is a major one, the chief engineer’s estimates 
will usually be the principal evidence used. 

The fourth problem—that of the amount of income available 
for dividends—stands in a class by itself and is plainly in the 
province of one group of specialists, the general or financial 
accountants. This problem calls for cost in an absolute sense, 
while all the others call for a comparison of the costs involved 
in two different policies. The only other problem which approxi¬ 
mates a search for absolute cost is the first; the entire sacrifice of 
raising capital and building a new plant, viewed prospectively, 
before the management commits itself to a decision. Here the 
alternative is not positive and specific, but negative and general. 
It is the alternative of staying out of this venture. One must 
needs assume that in any case some use will be made of the 
capital, labor, and brains involved, if not in this business, then 
in some other. However, no specific alternative is given, and 
none is needed in order to make a sufficiently workable reckoning. 
The rates of reward available in the general market are definite 
enough to serve the purpose. 


182 


ECONOMICS OF OVERHEAD COSTS 


With problem five, that of cutting prices to increase output, 
and indeed all the other problems with the possible exception 
of the taking on of a side line, we enter the realm of the cost 
accountant, or the region of problems where the chief data for 
solution must come from the cost accounts. These are problems 
of policy in a going concern and they hinge on a knowledge of 
costs, but they are all questions of alternatives, and do not hinge 
on cost in any ultimate or absolute sense. Problems five and 
six represent the differential or variable cost due to an increase 
or decrease of business; problems seven and nine hinge on the 
costs that cannot be avoided even if the plant stops working, 
and problem eight (the side line) represents the peculiar case 
of business which can be counted on to fill in the low spots in the 
utilization of the plant and working force without taxing their 
capacity when the high spots come. It is a problem of “ off-peak” 
business, not properly chargeable with its full share of the peak 
or capacity costs. 

Finally there might be raised certain broad questions of 
social policy, which are capable of being stated as problems in 
social accounting. When a shutdown is contemplated, what are 
the comparative costs involved from the standpoint of the busi¬ 
ness community as a w r hole, or of the nation ? Are there costs 
which one industry can throw off upon other industries, or one 
individual throw off upon other individuals ? Are there national 
overhead costs which are not borne directly by the business 
enterprises which are responsible ? This is not a business prob¬ 
lem, in the commonly accepted sense, but rather a problem for 
the statesman or the philanthropist. But it is rapidly becoming 
evident that statesmanship and philanthropy alone cannot 
solve it, and that unless business takes it up as a business 
problem it will not be solved. 

It is not necessary for business to become philanthropic and 
unbusinesslike; it is merely necessary to look at the productive 
machine as a whole and consider the effects things have on 
its aggregate efficiency. If a national chamber of commerce 
is possible as an organ of business, the corresponding nation-wide 
view of the business organism should also be possible. In this 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 183 

respect the study entitled, Waste in Industry , made and published 
under the auspices of the Federated American Engineering 
Societies, is a sign of much promise. But this is aside from the 
purpose of the present chapter However much these diffused 
costs may need to be studied as a matter of national cost account¬ 
ing, we are here concerned with costs in a narrower business 
sense. 

4. THE BASIC DATA 

Even before trying to solve these different problems, we can 
see in advance one feature of the results, namely, that the answers 
will all be different. No one formula could be made by an 
accountant which would distinguish between constant and vari¬ 
able expenses in such fashion that it could be used to get the cor¬ 
rect solution of every one of these different problems. But 
before this can be tested, we must sketch in the main facts about 
this fictitious plant. 

We are making, let us say, a five-passenger touring car or 
fabricated lifeboats of a uniform design, or any other fairly 
standardized commodity. We find that the demand for this 
sort of commodity fluctuates so that the minimum over a term 
of years is likely to be about half the maximum, and the average 
about three-quarters of the maximum. The plant we originally 
contemplate building, and the capitalization we plan to go with 
it, produce the following balance sheet: 


Assets {at Cost) Liabilities 


Land . 

m 

0 

0 

0 

0 

Common Stock. 

$100,000 

Buildings.. 

70,000 

Bonds (at 5 per cent).... 

100,000 

Machinery. . 

100,000 

Floating debt for working 




capital.... .. 

20,000 

Materials and working 




capital (when working 




at designed capacity).. 

20,000 



Total Assets. 

$220,000 

Total Liabilities. 

$220,000 


The capacity of this plant, when working an eight-hour day, 
is one hundred cars a year. In question 2 we shall consider 
larger or smaller plants, but this is our point of departure. Work- 












184 


ECONOMICS OF OVERHEAD COSTS 


ing capital, of course, will fluctuate with volume of business. 
Ultimately we hope to accumulate a surplus which will provide 
for working capital, but for the present we borrow it from banks. 

As for the cost of operation, any intelligent person could pre¬ 
dict that it would vary as output varied, though by no means in 
exact proportion. For some of our problems it is going to be essen¬ 
tial to know how it does vary, and we may as well know now as 
later. For this purpose we may construct a series of simplified 
budgets showing what happens to each main item, from a state 
of temporary shutdown up to a state of 20 per cent overload. 

Interest is included, not to prejudge the question whether it is 
• a cost or not, but because we shall need interest figures for some 
of our particular problems. The series of budgets is shown on 
page 185. 

Just a word as to the story that lies behind these figures. 
The labor force is so small that elasticity in the wage bill has 
to come mostly in other ways than from taking on or laying off 
full-time workmen. It comes through various things: piece- 
wage systems for the direct labor; part-time or overtime for 
most of the laborers (with overtime pay at extra rates), etc. 
When new men are taken on, there is waste in teaching them, 
and a certain amount of slackness due to the force feeling more 
secure of their jobs. The figures also assume that when output 
is pushed to 20 per cent beyond normal, accidents and spoilage 
of material increase out of all proportion. When men are laid 
off the rest work harder. There are certain “key men” whose 
experience in this particular industry is so valuable that they 
cannot be laid off without a very heavy loss, and they will be 
kept on even through a shutdown if it is not expected to be a 
long one. Promising learners may be favored somewhat. 
Materials and working capital are supposed to vary in proportion 
to the volume of business, and floating debt varies accordingly. 
Later, if the concern accumulates a surplus, the form of these 
items will change somewhat, but without material effect on the 
totals. Stockholders’ equity would be increased, and floating 
debt, now covering only a part of the working capital, would 
fluctuate more than output. 


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DIFFERENT COSTS FOR DIFFERENT PURPOSES 


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ECONOMICS OF OVERHEAD COSTS 


186 


There are many things of which such a table cannot possibly 
take account. One is, of course, the division of costs between 
different brands of output. Another is the subtle effect of time, 
for the cost of working steadily at 60 per cent capacity, for 
example, would be one thing and the cost of a few days’ operation 
at that rate, sandwiched in between days at full capacity or days 
of absolute shutdown, would be something different. Change 
itself costs something. The figures in the table may be taken 
to represent a rough average of these different sorts of conditions, 
neither the highest nor the lowest, and therefore we must not 
follow them slavishly, but be ready to make allowances for special 
circumstances. And with this caution let us turn to the first 
of our special problems. 

5. FIRST PROBLEM—TO BUILD OR NOT TO BUILD 

The plant will justify itself if it yields the investors as much 
or more clear income than they could have been reasonably sure 
of getting in any other line of investment. This means, of course, 
taking good years with bad and perhaps reserving something as 
compensation for the risk of ultimate failure or partial loss, of 
the sort which is suggested by the final problem in our series. 
When the original investors decided to devote their funds to 
this venture, their act cost them something; they sacrificed 
such rival opportunities as the market afforded for the investment 
of their funds, and unless this business compensates for that 
sacrifice, then they are out of pocket for having gone into it. 

It has been suggested that if a business man sacrifices one 
opportunity where he has a virtual certainty of large profits in 
order to embark on some other enterpise, the profits of the first 
business are a cost which he incurs if he engages in the second 
business. 1 In principle this is quite correct, if cost means any sac¬ 
rifice incurred as a result of undertaking the production of any 
given commodity. However, if we limit ourselves to what is 
typical, we shall rule out the case of a man who is certain of large 
profits in one industry and yet expects to be able to make larger 
profits in another. Such children of fortune are rare; moreover, 

1 See Davenport. Economics of Enterprise , pp. 60-64. 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


187 


no one can ever calculate just what profit he is giving up, and 
if one is going to label such a sacrifice a “cost/’ he should confine 
his estimate to things that are reasonably certain and calculable, 
for “cost” is supposed to rest as much as possible upon objective 
fact and as little as possible upon hypothesis. The market rate 
of yield on conservative investments is calculable enough for 
this purpose, but a hypothetical 25 per cent profit must always 
be a matter of chance. Six per cent on the entire investment 
would be a fair figure, and this amount is an essential part of the 
economic sacrifices involved in producing these goods. 

This fact alone would not make it necessary that the 
accountants should charge interest on the books as a cost; 
this is not needed to enable the investor to take it into his calcu¬ 
lations. The keeping of the books of account is governed by a 
number of other considerations, some of which favor including 
interest while others favor excluding it. What is needed, how¬ 
ever, is that accountants and others should recognize clearly 
that, even if interest is not treated as a cost in the general books 
of account, it must be reckoned as such for certain purposes, 
including the problem we have now before us. 

In the same way, if any of the owners contribute valuable 
services without salary, these constitute a sacrifice of production 
in the same way as the stockholders’ investment. The simplest 
way, for the accountant, is to pay a salary in such cases, and yet 
if a stockholder is willing to take his share in the profits as his 
reward, the concern is obviously that much safer, and nothing 
should be done to diminish that safety unless there is some 
stronger reason than mere convenience or consistency of account¬ 
ing ritual. Here again what is needed is a readiness, whenever 
a problem comes up which requires it, to take account of produc¬ 
tive sacrifices in the way of personal service even though the 
company does not pay a money stipend for them and they do 
not appear as a cost in the formal books. 

How shall we estimate operating expenses, in view of the 
fact that they vary with output ? In the first place it is obvious 
that if one estimated cost on the basis of always expecting to 
work at 100 per cent capacity, the answer would be too low. It 


188 


ECONOMICS OF OVERHEAD COSTS 


is equally true that, if 80 per cent represents average conditions, 
an estimate based on steady operation at 80 per cent of capacity 
would be too low. Overtime work is expensive, and work at 
60 per cent capacity is expensive, and work at 80 per cent to 
ioo per cent is more efficient than either, so far as operating 
expense goes, while the change from one to the other is expensive 
in itself. So instead of estimating the average rate of output 
and finding the cost of that, we should estimate the cost of 
working overtime, the cost of a shutdown, and of all the inter¬ 
mediate stages. And then we should average these costs, 
weighting them so as to give a fair picture of the probable facts. 
The table of costs already worked out will furnish the materials 
for this kind of an average. If we average all the columns, giving 
the “shutdown” column half the weight of the others, the result 
will represent an average output of exactly 80 per cent of full 
capacity, which is about what business men regard as a typical 
percentage and is made up in a fairly typical way. The resulting 
average is $1,300 per car, as compared to $1,287 P er car if pro- 
duction were steady at 80 per cent of capacity, and $1,134 per 
car when working at 100 per cent. 

The probable total economic cost per car, is, then, $1,300, 
if production averages 80 per cent of capacity. If the concern 
can sell eighty cars a year at an average price of $1,300, the 
enterprise will justify itself. If output is lower, cost will be 
higher and vice versa. In any actual estimate a wide margin 
would need to be added for errors and optimism, but we have 
already made a specific allowance for wastes of partial utilization, 
amounting to nearly 15 per cent of the figure for perfect utilization 
—which is frequently the only one actually calculated by an 
engineer. All estimates of cost should include a specific allow¬ 
ance for this factor before beginning to make more general 
allowances for omissions and unforeseen contingencies. 

6. SECOND PROBLEM—HOW LARGE TO BUILD 

An answer to the preceding problem really presupposes an 
answer to this one, but for convenience we may separate them. 
This question of size of plant is really a many-sided one, involving 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 189 

limits set by available capital, by the present demand, and by its 
prospects of future growth, but a full analysis of these would lead 
too far afield. There are, for instance, important principles 
involved in building ahead of present needs, in order to be pre¬ 
pared for future growth without the expense of rebuilding, but 
for the present we may confine ourselves to the question of 
the most economical size of plant. 

If an engineer were asked to make an estimate on such a 
question, he would probably have to build, on paper, two plants 
of different capacities and compare their costs of construction 
and operation. If he were very thorough he would do for each 
plant what we have already done for our original plant: that is, 
make a schedule of costs of operation at different percentages of 
capacity, from nothing at all up to an overload, and strike a 
fair weighted average in each case. 

The difference between these averages would represent the 
cost of the added output made possible by the larger plant. 
So long as there are any economies of large-scale production to 
be had, this difference in cost, divided by the difference in average 
output, would be less than the average cost for either one of 
the plants. However, if the plant outgrows its possible market, 
the economies of the large productive unit will be neutralized 
by the wastes of partial utilization. In practice, there would 
probably always be some economies technically possible, which 
would appear on an engineer’s estimate, but which might be 
counteracted or canceled by losses in efficiency due to the 
human factor; for there are limits on the power of the manage¬ 
ment to secure efficient co-operation in a larger and more 
complex enterprise. 1 Because of this inherent weakness of 
preliminary estimates it is very necessary to supplement them 
with data drawn from the past experience of similar concerns. 
This is what the experienced business man does, by judgment 
or intuition, if not by statistical analysis. 

How will the larger and smaller plants compare with each 
other ? An increase in size of plant will involve an increase in 

1 Alfred Marshall mentions some of these drawbacks of size: Principles of 
Economics, pp. 284-85; also in Industry and Trade , pp. 321-23. 


ECONOMICS OF OVERHEAD COSTS 


190 

practically every item of expense: interest on investment, taxes, 
depreciation, insurance, and operating expenses. The cost of 
securing added business, then, by increasing the size of the plant, 
includes a share of all these items, but not necessarily a pro rata 
share. In general, investment will probably increase faster 
than operating expenses, for the reason that the larger the plant, 
the more things it will pay to do by machinery and the smaller 
will be the proportion of direct labor to insurance, taxes, and 
interest on the equipment employed. Thus one writer has col¬ 
lected figures indicating that, in general manufacturing, operat¬ 
ing expenses per unit of product tend to decrease with increase 
in size of plant without apparently ever reaching a limit, and 
yet the largest plants are not the most profitable. 1 If this is a 
fact—and it seems plausible—it must be explained by the fact 
that overhead costs increase faster than operating expenses, 
overhead costs including all outlays on account of investment. 

Thus the fact that the costs of direct labor, or even total 
operating expenses, are smaller for the larger plant, proves 
nothing as to its being the most economical one; the question 
is: Does the saving compensate for the additional investment? 
For the sake of conservatism, some concerns never make a better- 
ment unless it can show a probable saving equal to double the 
interest on the capital involved. This would undoubtedly 
be wise policy in businesses which are not markedly stable, 
especially if the estimates of cost on which the whole caculation 
rests do not allow enough for partial utilization, or for the risk 
of premature obsolescence or for the fact that costs of labor and 
materials may change in the future in such a way as to vitiate 
the original estimates. For any such decision commits the 
concern for the life of the equipment in question, which may be 
ten or twenty years or more, and therefore the decision made 
today will have to justify itself under all the unforeseen contingen¬ 
cies of an entire future generation of machines. In some large 
industries, where a change of equipment cannot be made all at 
once because there is not enough capacity for making the new 

1 Kotany, “A Theory of Profit and Interest,” Quarterly Journal of Economics , 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


191 


equipment, the process must begin with the building of machines 
to make the machines which this concern is planning to instal, 
and this will look forward two mechanical generations or more— 
perhaps fifty years in all. 

Clearly the allowance for risk should be large, and the amount 
of risk depends partly on the size of the investment and partly 
on various elements of operating expense. These facts may be 
taken account of in a number of ways, but in all of them it is clear 
that the sacrifices which have to be compensated include sacrifices 
on account of capital invested, and that this embraces deprecia¬ 
tion, obsolescence, risk of loss, and interest on the entire invest¬ 
ment; whether covered by bonds, stocks, or floating debt is an 
incidental matter. 

7. THIRD PROBLEM—A CHANGE OE PRODUCTIVE METHODS 

All that has been said about the economies of large-scale 
production applies equally to any proposed change in methods 
of production involving a change in the capital equipment, with 
one additional feature, namely, that a new method may involve 
scrapping some existing equipment prematurely as well as install¬ 
ing new. This complicates the estimate of capital costs, but 
at the same time makes some sort of estimate even more obviously 
necessary, since it is self-evident that operating expenses alone 
are only a part of the story. 

To attempt to go into all the complexities of premature 
abandonment would be out of place here, as it presupposes a 
knowledge of the principles governing abandonment that is not 
premature—itself a rather large question. For the present we 
may start with the case in which the old equipment is ready to 
be scrapped and replaced in any event. Then it is clear that the 
new process must save enough in operating expenses to cover 
depreciation and interest on the extra investment involved; 
in other words, the excess of the cost of the new type of equipment 
above the cost of replacing the old. In order to justify scrapping 
the old equipment before the end of its natural term of life, 
instead of waiting, the saving would need to be larger, but just 
how much larger we cannot take time here to calculate. 


192 


ECONOMICS OF OVERHEAD COSTS 


However, the installation of the new plant need not bear 
the whole loss involved in writing off the value of the old, for 
one very decisive reason. The old plant loses its value, not 
because it is replaced, but because there is a new process which 
does the work better than the old plant can do it, and so makes 
it economical to replace it. This is equally true, whether the 
company recognizes the fact or not, whether it scraps the old 
equipment or persists in keeping it in service. If it is kept in 
service, its value is still its scrap value and nothing more. The 
act of scrapping the old plant and replacing it is merely a 
recognition of a loss already incurred. 


8. FOURTH PROBLEM—INCOME AVAILABLE FOR DIVIDENDS 


Those who have this problem to meet are the financial 
accountants, and if this were their only function, their definition 
of cost would probably be governed accordingly, and would 
include any and all obligations which must be met before 
dividends can be paid. These obligations include all operating 
expenses, depreciation, taxes, and all interest which the corpora¬ 
tion definitely contracts to pay on either its floating or its funded 
debt. Dividends, however, are not a legal liability, and even 
in the case of preferred stocks they do not carry the power to 
put the corporation into bankruptcy if they are not met. On 
this basis interest on debts would be a “cost,” but interest on 
^investment represented by stocks would not be. From a broader 
r standpoint, it represents sacrifices of production made by the 
stockholder, but for the purpose in hand this does not matter: 
. what matters is that the corporation as such does not legally 
owe anyone this amount of money. 

However, the books of the accountant are not used for this 
purpose alone. They are also frequently referred to as indexes 
of economy and efficiency, as records of the economic sacrifices 
involved in production. For this purpose, interest on debts, 
taken by itself, is clearly irrelevant. It would be absurd to 
suppose that one concern has heavy expenses because it has a 
large bonded debt and that another concern, with the same invest¬ 
ment and operating expenses, has light expenses because its 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


193 


capitalization is all in the form of common stock. Cost means 
nothing as an index of the sacrifices of production when it includes 
items which depend, not on the total expenditure of resources in 
the course of producing goods, but merely on the form of financial 
arrangement under which the capital resources were raised. 

Books whose primary purpose is to show how much income 
is available for dividends cannot easily be made to show as 
“expenses’' all the sacrifices of production, and the only ones 
they can show on a basis that would be fair and comparable as 
between different concerns are the “operating expenses.” Even 
these are ambiguous where an owner works for himself without 
salary, for here again the financial obligations of the industry 
fail to cover all the sacrifices made for the sake of the product. 
However, in most cases they are fairly comparable as far as they 
go. Accordingly it is natural that the income account should 
confine the term “cost” to operating expenses. Taxes and 
interest on bonds then become “deductions from income,” 
and these, with operating expenses, together make up the sum 
of charges that are prior to dividends. This does not mean 
that “operating expenses” are the only expenses of production, 
but merely that they are the only ones of industrial significance 
which the income account can conveniently report consistently 
with its main purpose. This main purpose is financial and not 
industrial: the measuring of income available for dividends rather 
than the gauging of the economic efficiency of different processes 
or methods of production. 

A company must have an income account, and it is foolish 
to quarrel with the forms which the accountant finds necessary 
and convenient for this purpose, so long as they do not set up 
to be more than they are, and are not forced to do duty for other 
purposes for which they are not adequate. We have seen that 
if we wish to decide whether to build a plant, how large to build 
it, or whether to instal new equipment, we must take account 
of interest on the entire equipment in question. If the financial 
accounts cannot conveniently do this, well and good, but that 
should not act as a veto on the inclusion of interest by the engineer 
or the cost accountant wherever their peculiar problems require 


194 


ECONOMICS OF OVERHEAD COSTS 


it. There have been too many absolutes in accounting as in 
other arts and sciences, and an absolute generally means a con¬ 
ception which may be adapted to one purpose, but is arbitrarily 
used for other purposes which it does not fit. 

9. FIFTH AND SIXTH PROBLEMS—DIFFERENTIAL 
COST OF ADDED OUTPUT 

In cutting prices to secure additional business for a plant 
already built, we encounter cost in a new aspect. The cost 
attributable to the additional business is, strictly speaking, the 
difference between the cost of producing the larger output and 
the cost of producing the previous smaller output. This differ¬ 
ential cost consists largely of an increase in the direct operating 
expenses, but it includes many other elements, even a trifle of 
interest on the increased working capital. Turning back to the 
table, we can see that 60 cars cost $51,120 more to produce than 
no cars, or $852 per car; 80 cars cost $10,180 more than sixty, 
or $509 per additional car; 100 cars cost $10,400 more than 
eighty or $520 per additional car, and 120 cars cost $24,940 
more than 100, or $1,247 P er additional car. 

These “differential costs” are often the decisive thing in 
determining how cheaply the concern can afford to sell additional 
goods. They do not correspond with any possible accounting 
category. For the first sixty cars they are more than the direct 
operating expenses but less than total operating expenses; for 
the next forty they are a shade under the direct operating expenses 
and for the last twenty cars they exceed the average cost at 
full capacity, including all overhead charges. There is no 
percentage division of expenses into “constant” and “variable” 
which could possibly produce this set of answers. Nothing 
would furnish data for it except a study of the actual changes in 
total cost produced by changes in output. 

If the additional output can be disposed of by “dumping” 
or in any other way which makes a separate class of it and leaves 
existing business absolutely unaffected, then the minimum 
limit below which the concern cannot afford to cut prices is 
simply the differential cost. Anything above this is a gain. 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


195 


On the other hand, if the goods have to be sold all in the same 
market, by reducing the price to all customers, the case is not 
quite so simple. We may start with the assumption that the 
concern is marketing eighty cars at $1,100 each. This means 
that no interest is being earned, and little depreciation. Then 
if they were to cut the price to $900 in order to increase their 
output to full capacity, their gross income would be increased 
very little, only from $88,000 to $90,000, while their expenses 
would be increased by $10,400 and their total net income would 
be decreased by $8,400. Calculation will show that they must 
charge $984 on 100 cars in order to be as well off as they were 
before. 

On the other hand, if they were previously selling the same 
eighty cars at $1,400, and reaping a profit of $9,000 above 
interest, the smallest price which they could afford to accept 
in order to push their output to 100 would be $1,224, otherwise 
their net earnings would be reduced. Or, thirdly, if they were 
selling eighty cars at $1,287 each, and just covering all of the 
interest charges, then the minimum price at which they could 
afford to sell their capacity output would be $1,134. 

There are many special circumstances that would need to be 
taken into account, and which have not yet been touched upon. 
Three of these may be worth mentioning: first, the size of 
single orders; second, the question whether goods are sold 
immediately or whether a contract is made calling for deliveries 
well into the future; and third, the question what to do about 
materials which the concern has either bought or contracted to 
buy at a given price, in case the price changes, particularly if it 
goes down. Let us take these up in their order, taking, first, 
the question of many small sales versus a few large ones. 

In the securing and filling of any given order, there are some 
costs which are virtually overhead costs for that order, although 
they may vary with the number of orders a firm secures and fills. 
In gas and electric light utilities there are some expenses which 
vary approximately with the number of customers served, 
regardless of size. These consist largely of accounting, bill 
collecting, and meter reading, together with interest and depreci- 


196 


ECONOMICS OF OVERHEAD COSTS 


ation on the meter and on the minimum customer’s connection. 
In a manufacturing plant such as we are studying here, there 
would be some selling expenses that would not vary with the 
size of the order—a great deal of the accounting, the cost of 
planning and of making patterns or securing any other special 
equipment that might be needed. All this would make it possible 
systematically to quote slightly lower prices for large orders than 
for small ones, the discount depending on the importance of these 
items of cost which do not vary with the size of the order. From 
the standpoint of the business as a whole these may be strictly 
“variable” costs; they may, for example, vary exactly in propor¬ 
tion to the number of orders taken. But with reference to the 
size of the orders they are to be treated as constant items. 

Secondly, what difference does it make how long ahead one 
takes orders binding him to deliver goods ? The element of risk 
obviously varies. If one has already bought materials enough 
to fill all his contracts, then these contracts, calling for delivery 
at definite prices, reduce his risk rather than increase it. If, 
however, he has not yet bought his materials, a rise in price may 
cause him a loss and he is likely to find it wise to hedge against 
this loss if there is a speculative market on which he can make 
a hedging contract. Another element of uncertainty is the 
uncertainty of how busy the plant will be at any given time. 
On the whole, making contracts ahead tends to reduce this 
uncertainty if the product is something that can be made to stock, 
because the contract enables the concern to make more goods than 
they can sell in dull times, and still be sure of an ultimate market. 
In any case, the cost on which the manager is to calculate, then, 
is an indefinite, probable cost based on a fair estimate of what 
the conditions are likely to be. In such a case, the exact points 
on the curve of cost are not important and the difference between 
the cost of raising the output from 80 per cent to 90 per cent 
capacity,and raising it from 90 per cent to 100 per cent capacity 
will not count. The important thing will be the general trend 
of the curve of cost. For such purposes a rough, rule-of-thumb 
formula may be the most useful thing, even if it is not exactly 
accurate. 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


197 


With regard to material already bought, there is a possible 
conflict between accounting convenience and commercial fact. 
If a firm bought materials in advance and the price subsequently 
fell 50 per cent should the cost accountant use the actual cost 
or the present market value in figuring the cost of making these 
materials up into finished products? The principle involved is 
the same when a concern, without having actually bought mate¬ 
rials in advance, has contracted to buy them at a fixed price. In 
reporting the finances of the concern, the actual cost of these 
materials is the cost which the firm actually incurred. Anything 
else, from that standpoint, would be a fiction. But with reference 
to filling an order which comes in after the price goes down, the 
cost of materials already bought is one of those matters of ancient 
history which has nothing to do with the question: What addi¬ 
tional expenses are incurred as a result of filling this particular 
order ? What the concern expends now is materials which it now 
has, not the money which it paid out for them some months ago, 
and the sacrifice now involved in putting these materials into 
a given order is really represented by what the concern could 
realize on these materials if it did not make them up and sell 
them to this particular customer. This sacrifice is measured 
by the market price of the materials and not by the original cost. 
The difference between the two is a loss due to holding goods 
whose price has fallen, and this loss should not be charged as 
a cost of making these materials into finished products. 

A firm has been known to lose numbers of contracts because 
it kept on figuring its bids on the basis of the original cost of 
materials after the market price had fallen heavily. They were 
refusing to make bids low enough to secure the orders because 
these orders would not otherwise cover certain costs which they 
had incurred in the past. But such historical considerations 
have nothing to do with the question: What will our cost be 
next week if we take these orders, compared to what they will he 
next week if we do not take them ? It is more convenient to charge 
materials at their original cost, but it is possible to charge them 
at the market price prevailing at the time they are used, and thus 
to separate gains and losses arising out of the producing of goods 



iq8 economics of overhead costs 

from gains and losses due to changes in the value of materials 
in stock. This is done by a number of concerns, and is certainly 
the more accurate practice. Wherever materials are charged 
at their original cost, the management needs to bear in mind the 
fact that the costs as thus reported are bygones and should be 
re-examined in the light of present market values if it appears 
likely that such a re-examination would give rise to a different 
decision in matters of price. 

The problem of reducing prices in time of depression (the 
sixth in our series) is substantially the same as the problem of 
increased output worked backward. There is a difference, 
however, that is not shown in the table of figures. There are 
costs due to disturbance as such, and these furnish an added 
argument for cutting prices to retain existing business, while 
they work in the opposite direction when it is a question of 
expanding sales. Whether this item is large enough to be 
worth considering will depend on circumstances. In most 
cases it is probably negligible compared to other factors, known 
and unknown, which enter the problem. 

IO. SEVENTH PROBLEM—A TEMPORARY SHUTDOWN 

This problem hinges on the fact that certain people w r ould 
need to be kept on the pay-rolls as a nucleus around whom the 
organization could be built up again when production should be 
resumed. The backbone of the office and sales force would have 
to be kept and the key men in the other departments, while a cer¬ 
tain amount of materials would have to be expended for repairs, 
and watchmen would be employed as before. In this case we 
have assumed that it costs $41,700 to turn out no output at all, 
and $51,120 more to turn out sixty cars, or $852 per car, so that 
it would pay the concern to cut prices down to that point, rather 
than to shut down entirely. The total income on this basis would 
not cover operating expenses, but it would come nearer covering 
them than if the income were nothing at all and the operating 
expenses of keeping the nucleus of the force together had to be 
met somehow, The corporation might be unable to finance 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


199 


such a policy and might go bankrupt, in which case a receiver 
would have the same problem facing him. In the ordinary 
case, however, if the emergency is a temporary one, the deficit 
can be met out of previous surpluses. The cost of keeping the 
nucleus of the force through a temporary shutdown is really 
chargeable against all the future business the firm expects to do 
after conditions improve and it becomes possible to reopen. 

II. EIGHTH PROBLEM—A SIDE LINE 

One way of keeping plant and personnel working steadily is to 
take on some side line which will help to fill in slack periods. In 
connection with any such side line there are two distinct ques¬ 
tions. One is the cost involved in installing it and the income 
which it must show in order to justify the installation. The 
other is the cost of keeping it going after it is installed, and the 
two differ to the extent that specialized investment may have 
been made that cannot be redeemed to any other use. Since 
a side line of this sort is somewhat speculative and the special 
equipment needed for it cannot, in the nature of the case, be 
utilized very continuously, it stands the best chance of success 
if the special equipment needed is small. In deciding whether 
to undertake such a side line, the prospective income must be 
enough to cover interest, taxes, and depreciation on any special 
investment required, and these charges for the full life of the 
investment must be covered during the relatively limited time 
in which it is working. As for operating expenses, such a side 
line needs to be charged only with the difference in the budget 
which results from keeping the existing labor working on the 
side line rather than laying off all those who do not have to be 
kept as a nucleus in any case. 

This last is itself an elastic quantity depending largely on 
judgment, and the existence of a side line which can utilize spare 
time may make it possible to keep on numbers of experienced 
workers who would else be laid off, and, in estimating the cost of 
producing the side-line product, the wages of such laborers do 
not properly count in full. It would be proper to deduct the cost 


200 


ECONOMICS OF OVERHEAD COSTS 


of labor turnover which Is avoided by keeping such men on the 
pay-rolls. As a result the labor cost chargeable against such a 
side line would often be very slight. 

12. NINTH PROBLEM—ABANDONMENT 

By the time this problem comes up for settlement the concern 
is generally in the hands of a receiver, and he has to decide in the 
equitable interests of all concerned (but primarily the mortgage 
bondholders) whether it is worth while to go on operating the 
property. The crucial consideration here is what can be realized 
on the property if production is abandoned. The original cost 
is a bit of ancient history, but the plant must still earn something, 
or it will be better to scrap it. The land still has value, the 
materials and working capital can be realized on without much 
loss, the building may, with considerable wastage, be readapted 
to some other use, and the machinery can be sold at a scrap value. 
Let us assume that $70,000 can be realized in this way on the 
land and fixed equipment and $10,000 on the materials and 
working capital, or a total of $80,000. 

If the concern is to go on operating there must be a prospect 
of yielding a return which would be worth, and would justify, 
$80,000 of investment sacrifice. Operating expenses, of course, 
must be covered. As for depreciation, nearly all the depreciation 
possible has already occurred. Perhaps the present salvage 
value of buildings and plant is $20,000 more than the ultimate 
scrap value would be if they were allowed to wear out in service. 
Depreciation on this would hardly be more than $800 per year, 
though it might be more if the remaining useful life of the plant 
were short. Interest would have to be earned at, say, 6 per cent 
on $80,000 or $4,800 per year, and taxes would have to be covered 
at whatever they could be scaled down to—perhaps $1,500 a year. 
This would give a total overhead (other than floating debt) 
of $7,100 in place of $23,400. This reduction of overhead 
would cut the necessary price from $1,300 to a trifle under $1,100, 
though perhaps something should be added for added risk in 
view of the bad record made so far. This $1,100 per car repre¬ 
sents the cost of staying in business after having once set up a 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


201 


plant, while the $1,300 represents the total sacrifice involved 
in setting up the plant and operating it. If this total sacrifice 
cannot be covered, the appropriate thing is to scale the amount 
down to $1,100 and continue in business, if there is a reasonable 
prospect of selling a normal output at that price. This is con¬ 
siderably less than the average price necessary to justify the 
original investment, but it is a great deal more than is necessary 
to justify keeping the plant open for a short time if there is 
prospect of a recovery in business. 

13. CONCLUSION 

It is evident that in these nine different problems we have to 
deal with cost in different aspects and that no one formula for 
cost will fit all the cases. In the first case we dealt with the 
whole economic sacrifice of building a plant and operating it. 
In the second we dealt with the long-run added cost of added 
capacity. In the third case we did not change our output, but 
considered the cost of a new method of producing it. In the 
fourth we dealt with the financial expenses legally payable by 
the corporation. In the fifth, sixth, and seventh we dealt with 
the difference in cost attributable to a difference in business. 
In the eighth we dealt with a special case of this same problem, 
namely, the question of operation versus temporary shutdown, 
and we ended by* studying the cost of continuing in business 
rather than going out of business permanently. 

It turns out that cost in the first sense includes taxes, depre¬ 
ciation, and interest on the entire investment. Cost in the 
second sense is likely to be somewhat less, but is a matter of 
engineering estimate. Cost in the third sense includes interest, 
but cost in the fourth sense does not. Cost in cases five to eight 
includes much or little, according to conditions. The cost 
attributable to an additional unit of business is generally less 
than its pro rata share of operating expenses, but when it comes 
to pushing the plant beyond its designed capacity this differential 
cost rises until it exceeds a pro rata share of operating expenses 
and overhead costs together. Lastly, the cost of continuing 
in business, rather than going out permanently, includes interest 


202 


ECONOMICS OF OVERHEAD COSTS 


on the salvage value of the investment and no more, and virtual^ 
no depreciation. 

One slightly surprising thing is that we have two costs of pro¬ 
ducing the same output. The cost of producing sixty cars 
rather than none is $852 per car if the alternative is a temporary 
shutdown, or nearly $1,100 if the alternative is to go out of 
business permanently. But how can the cost of the same operation 
be different according to such an intangible test as whether the 
alternative is shutting down temporarily or permanently ? Cost,it 
might seem, has to do wfith what is, and not with what might be. 

The fact is that we are dealing 'with cost in at least two very 
different senses. There is cost in the absolute sense, of which 
case three offers one illustration. Cost in that sense is a present 
fact which cannot vary according to hypothetical alternatives. 
However, when one is making a decision of a financial sort, one 
needs to know the costs incurred as a result of making this partic¬ 
ular decision; meaning costs which would not have been incurred 
otherwise. In other words, we have to deal here with what we 
may call “alternative costs.” Every judgment on a matter of 
policy needs this kind of an estimate of cost if it is to be intelli¬ 
gently made. 

Now, while accounting cannot be expected to report “alter¬ 
native costs” in a finished state, cost accounting should furnish 
the raw materials from which the manager can make these 
comparisons. And this means, for one thing, that interest should 
be included in the raw data gathered by the cost accountants 
and should be used in various sorts of special studies of costs, 
whether it is regularly included in the officially reported costs or 
not. These special studies might be illustrated by the table we 
have already used showing how costs vary in response to changes 
of output. This clearly implies a careful study of costs for many 
weekly or monthly periods, an attempt to eliminate irrelevant 
causes of change, the selection of something which will serve as 
a unit of output, and a final conclusion as to the effect of output 
on costs, other things remaining equal. This is a very difficult 
analysis, involving some arbitrary quantities and much exercise 
of judgment, and therefore the story it tells, and, in particular, 


DIFFERENT COSTS FOR DIFFERENT PURPOSES 


203 


the figure representing the differential cost of added output, is an 
inference rather than a simple fact of record. But for that 
matter, whenever a cost accountant reports the cost of a particu¬ 
lar job, including a share of indirect costs, the result is an infer¬ 
ence rather than a simple fact of record. It is merely a different 
kind of an inference, and both kinds are valuable. 

The peculiar value of estimates of differential cost lies in 
correcting certain natural errors into which a business man may 
be drawn by looking merely at total costs. He knows that 
costs are low when business is active and that he makes most 
of his money “on the peak,” and he is likely to infer that the 
peak is a desirable thing and that costs at other times are higher. 
Yet the added cost resulting from added business is lowest when 
the plant is working at part capacity and when the plant reaches 
the point of lowest total cost per unit, the added cost due to 
added output has already risen enormously and will rise still 
more with every further increase of business. As a result, to 
sell five more cars, for instance, at $1,100 apiece might be a fine 
stroke of business when the plant is partly idle, a doubtful gain 
when it is working nearly full time and a positive loss when it is 
working overtime. This would be true without taking account 
of the further possibility that if the peak were cut off the invest¬ 
ment could be made smaller without losing any of the off-peak 
business. If this were possible, then the differential cost of the 
peak business would be still heavier, for it would include part 
of the overhead charges that go on through the off-peak periods. 
So far, in our study, we have ignored this possibility, and justi¬ 
fiably so, since it would require something different from ordinary 
business tactics to refuse business at the peak without losing 
customers at off-peak times also. However, means might be 
found for overcoming this difficulty, and then the differential 
cost of the peak business would go up. 

Thus the behavior of average costs does not tell the whole 
story, and “differential costs,” conjectural though they be, are 
important to estimate. 




CHAPTER X 

WHAT IS A UNIT OF BUSINESS? 

SUMMARY 

Division of costs into periods, 204—Costs of different kinds of output, 206— 
A method of approximating differential cost for a variegated output, 208—Different 
dimensions of output, 210—The size of the unit of business, 213. 

I. DIVISION OF COSTS INTO PERIODS 

The assumption underlying a considerable part of the 
argument of the preceding chapter is that it is a good thing 
to know how much difference is made in costs by a difference 
in volume of business, or by a difference in methods of production, 
or by any other difference in commercial or industrial policy. 
Of course, if it would be of no use to know these things, then 
there is no use in wasting time studying how these differences 
in cost behave or trying to discover the best ways of estimating 
them. However, there is such a widespread awareness of the 
general facts of constant and variable expenses that business 
men are continually doing things which imply a knowledge of 
the manner in which costs vary, so that if they do not act on 
a correct understanding they will merely be acting on an incorrect 
one. Therefore the question arises: How near is it possible 
to come in an actual business to the ideal condition assumed in 
our fictitious case, in which we knew exactly what increase in 
costs a given increase in business was responsible for? Would 
it be practicable to construct a table showing these facts for an 
actual industry ? 

In the first place, the expenses would have to be divided 
into periods and charged against the goods produced in those 
periods. This problem has already had the benefit of much 
v expert study, as it is one of the central problems of financial 
or general accounting. It presents a number of very real diffi¬ 
culties, because the money spent in a given week or month 
might not be solely on account of the output of that period, 


204 


WHAT IS A UNIT OF BUSINESS? 


205 


and the progress made in pushing goods toward completion 
might not be accurately measured by the amount of work actu¬ 
ally finished and sold. Where the product takes some time to 
make, it would be necessary to resort to the device used in ship¬ 
yards, reporting progress in terms of “ percentage of completion,” 1 
or some similar index. 

Materials would of course have to be reported as a cost 
of production at the time they are used, rather than when they 
are bought. As for maintenance, it would be hard to make the 
figures mean anything for the purpose in hand. Maintenance 
expenditures for a given year ought to correspond roughly to 
the wear and tear which calls for maintenance expenditures 
and which results from the business of that year. But though 
these ought to correspond, too frequently they do not. Plants 
are allowed to run down, or permanent improvements are made 
and charged to maintenance. And for periods as short as 
a month there might be little or no connection between the 
wear and tear occurring and the actual expenditure for mainte¬ 
nance in that particular month or week. The very rush of work 
that jars bearings loose and wears down running parts may make 
it out of the question to stop the machine for repairs as long as 
it will run at all. Thus the repairs due to one week or month 
of heavy business may appear largely in the following week or 
month, while some of them may have been made in anticipation, 
and may appear in the preceding week or month. It is just 
possible that an able statistician might work out a formula 
for the distribution of the maintenance due to a given amount 
of work—so much in the same month, so much in the preceding 
and so much in the succeeding month—which would fit the 
curves of actual costs convincingly and shed light on the 
question: How much effect does additional business have 

1 This device itself covers up a multitude of difficulties, for what is 10 per cent 
of a ship or of an automobile ? What is the equivalent in keel plates of the caulking 
of 10 square yards of deck or the rigging of the foremast stays? An impossible 
question, yet there appears to be an answer which is true enough to be useful, 
whatever its logical shortcomings. Perhaps cost of keel plates, deck, or rigging 
material and installation would be an adequate common measure, though there 
would still be the indirect costs to allocate! 


206 


ECONOMICS OF OVERHEAD COSTS 


in increasing maintenance expenses? Even this would not 
prove that the expense was not concentrated in active 
periods because those were the times when the concern had 
funds available to spend, rather than because the need was 
peculiarly great in just those months. Some railroads divide 
their yearly budget of expenses for “ maintenance of way and 
structures” into twelve equal parts and charge each month with 
an equal amount regardless of when the expenditures are made. 
Evidently they consider that the actual fluctuations are mostly 
due to irrelevant causes and would be more misleading than 
otherwise if reported month by month as made. Now if the 
actual fluctuations can tell no reliable story to a statistician it 
becomes necessary to fall back upon the next best thing, which 
is the judgment of the expert as to the amount of wear-and-tear 
which takes place. This would be only too fallible, but perhaps 
the best expedient at hand. 

2. COSTS OF DIFFERENT KINDS OF OUTPUT 

Another set of problems arises from the fact that virtually 
all concerns produce a mixed output, so that, no matter how much 
we study the variations of the total expenses, there will still 
remain the task of allocating them to different brands, qualities, 
and types of work. This task takes on so many different forms 
that it appears almost hopeless to generalize about it. There 
are the different seats in a theater—floor, boxes, and balconies. 
There are the different rooms in an office building or a hotel— 
inside and outside, upper and lower floors, etc., and different 
locations of floor space and window space in a department store. 
A machine shop turns out different kinds and sizes of machines, 
some in large quantities and some in small. And, as we have 
already seen, the larger machines are cheaper to produce per unit 
of capacity. A publisher turns out different kinds of books, in 
larger and smaller editions. A retailer sells goods with or 
without delivery, and for cash or for credit. Machines are sold 
with or without guaranties, and with or without costly services 
of demonstration and free repairs. Purchases are large or small 
and packages are large or small. 


WHAT IS A UNIT OF BUSINESS ? 


207 


Even where a product can be reduced to units of some homo¬ 
geneous quantity, there is often a perplexing variety of dimensions 
to choose from, for example, shipments, tons, and ton-miles 
in the case of freight, with further possible allowance for the dead 
weight of cars, which varies according to whether the cars are 
fully loaded and whether there is a return load or not. There is 
service at different hours of the day, different days of the week 
and different seasons of the year, all of which things may affect 
both value and cost, especially differential cost. Some goods 
almost sell themselves, while others require expensive selling 
services, some sell quickly and others more slowly. Some classes 
of telephone sendee require special speed, and this has to be 
given to all classes alike, both those to which it is essential and 
those to which it is merely an added convenience. In varied 
farming some branches are more or less complementary to each 
other and some are not, and farmers often have no clear idea 
which branches are profitable and which are burdens. 

Evidently these cases are so different as to call for very 
varied treatment, and it would be out of the question to make 
one simple prescription to fit them all. There are, however, 
certain general methods out of which any system of analysis 
must be built. 

In the first place, it is possible to divide the total expenses 
up, assigning every item to some product, or subdividing it and 
assigning shares to different products, so that all the costs are 
charged against different classes of product. But this tells 
us nothing about differential costs. Costs as allocated in this 
way could not possibly correspond with differential costs except in 
certain stages of output, and if we depend solely upon allocating 
expenses we shall never know what increased or decreased output 
really does to costs. Moreover, it is not easy for people trained 
in this sort of accounting, where the whole is necessarily equal 
to the sum of its parts, to take up the very different kind of 
analysis involved in a study of differential costs. For the 
sum of differential costs may be greater or less than the whole, 
sometimes by very large amounts; and the entire process of 
allocation must be freer and less conventional than the arith- 


208 


ECONOMICS OF OVERHEAD COSTS 


metical addition of items which forms the backbone of accounting 
procedure. 

On the other hand, if analysis were to depend solely upon 
watching the variation of costs, we should find the results quite 
baffling in a different way. If we could try unlimited experi¬ 
ments in the variation of costs, it would be found that the differ¬ 
ential cost of product A depends partly upon the volume of 
product A turned out, and partly upon the volume of other 
products B , C, D , etc., turned out by the same plant. If the 
only evidence we could use to determine the differential costs 
of these different products were the actual variations of total 
cost, it would be necessary to get one series of observations cover¬ 
ing different rates of output of product A while B, C, D , etc., 
remain constant; then a series of these series, representing 
different rates of output for product B, while C, Z>, etc., 
still remain constant; then a series of these series of series 
representing different volumes of C, and so on for as many 
products as the plant turns out. Fortunately, this impossible 
method is not necessary in order to get a useful idea of the vari¬ 
ation of costs for plants turning out a varied output. It is 
possible to combine the method of allocating expenses with 
the method of observing variations, and secure useful results 
without prohibitive labor. 

3. A METHOD OF APPROXIMATING DIFFERENTIAL COST 
FOR A VARIEGATED OUTPUT 

In the first place, where the differential cost of A depends 
on the volume of A turned out, rather than on the general output 
of all products, this is clearly because there is certain equipment 
and perhaps certain skilled labor that is specialized to make 
this product, so that when it is only partly utilized there is waste 
and when it is pushed beyond its capacity costs rise. 

But where this is the case any official would know it without 
being told by his cost accountants. Certainly it would not 
require an observation of series of series of statistical data to 
determine the fact. In the same way, where the differential 
cost of A depends upon the output of £, this may be for two 


WHAT IS A UNIT OF BUSINESS? 


209 


reasons. They may be joint or complementary products in 
the strict sense or they may make use of some common equipment, 
such as cranes or a power plant, or the same skilled labor may 
work interchangeably on both kinds of product. Again, if this 
is true, any official would know it without needing a statistical 
investigation to inform him. 

It would be possible, then, to divide the expenses into those 
specialized to product A, product B, etc., and those devoted to 
all the products or a considerable number of them, and then 
proceed to study how the specialized expenses vary in reponse 
to changes in their special products, and how the generalized 
expenses vary in response to the general changes in the volume 
of business. Since these generalized expenses are likely to have 
to do with some physically homogeneous thing like power, the 
question of a unit to measure the variations of utilization will 
frequently take care of itself in very simple fashion. Horse-power 
is not a unit of business, but for purposes of studying the effect 
of increased business on the general item of power, horse-power 
is the unit to use. 

It would be possible, then, to report the cost of everything 
in a twofold way. First, the cost could be reported in regular 
accounting fashion, item by item. But beside every item would 
be another figure, representing the differential cost of the work, 
in the prevailing state of utilization of the general and special 
equipment and labor force. One way to arrive at this supple¬ 
mentary figure would be to study, for instance, the shape of the 
curve of cost for power as it varies in response to different rates 
of output. This would, of course, require a skilful survey- 
analysis based on the past experience of the plant for a consider¬ 
able time, and of other plants also, if the records could be had. 
From this curve could be derived the percentages of differential 
cost per horse-power to average cost per horse-power, for each 
point on the curve. This percentage would usually be very small 
for a plant working at a small part of its capacity, and might 
rise above 100 per cent when the plant is being pushed hard, 
especially when there is overtime to be paid for at extra rates. 
Suppose that it is 25 per cent when the power plant is working 


210 


ECONOMICS OF OVERHEAD COSTS 


at 60 per cent of capacity. Then a piece of work, done when the 
plant is working at that rate, and charged with $10.00 as its 
full share of the cost of power, would be rated at $2.50 as its 
differential cost for power. Treating all other items in the same 
way, one would have a figure for the differential cost of that 
particular job, and could guide his decisions accordingly. 

Of course, it would be expensive to report the cost of every 
item of output in this dual fashion, and probably the same 
result would be attained by doing it only now and then: sampling 
the run of the business whenever the management might feel 
in need of the information. The underlying survey of curves 
of cost and utilization, once made, would have to serve a consider¬ 
able time in order to justify itself. A small plant could not afford 
to make such a survey at all, but in such a case the industry as 
a whole would generally find it worth while to have a survey 
made for the benefit of all alike. Wages and costs of materials 
might change but these changes would not greatly affect the 
percentages of differential cost to average cost, so that these 
could be used for a considerable time. . 

This is, of course, only one possible suggestion. The results 
of a cost survey might indicate that some simpler approximation 
would be close enough to serve all practical purposes. For 
example, in the hypothetical case discussed in the preceding 
chapter, differential cost is almost identical with direct operating 
expenses per unit, except at the upper and lower ends of the 
curve. In such a case one might simply take for granted, 
within proper limits, that direct operating expenses are a measure 
of differential cost. This would be very different from taking 
the same thing for granted without any cost survey to tell if it 
approached the truth, and without any regard to the limits within 
which it might be true. 

4. DIFFERENT DIMENSIONS OF OUTPUT 

For certain purposes managers would wish to know the long- 
run additional cost of increased output where additional equip¬ 
ment would be required to handle it. This would require a 
different sort of survey based if possible on the experience of 



WHAT IS A UNIT OF BUSINESS ? 


211 


many plants, and, if that is not to be had, on engineering esti¬ 
mates. 

For such purposes, and for some others, it may be found 
convenient to reduce all varieties of output to some arbitrary 
unit, but it goes without saying that all such units must be 
used with the greatest caution. In the case of railroads the 
ton-mile is quite an arbitrary unit for freight, good only for 
comparisons that involve no marked change in the make-up 
of the traffic—no large increase in package freight and falling- 
off of coal, or vice versa. As for passengers, they are frequently 
merged with freight in a composite unit or “equivalent ton-mile,” 
consisting of one ton-mile of freight or somd specified fraction 
of a passenger-mile. For instance, Dr. M. O. Lorenz, statistician 
of the Interstate Commerce Commission, has made a calculation 
in which every passenger-mile counts as the equivalent of 3.67 
ton-miles. This particular figure was selected because then the 
revenue per “equivalent ton-mile” would be about the same as 
the revenue per ton-mile of freight. 1 The unit really is, then, 
a ton-mile of freight or an amount of passenger-travel that yields 
as much revenue. In this sense, it is a unit of earnings. Some¬ 
times a unit of cost is chosen instead, though this obviously 
presupposes that the roads have already made an accounting 
separation of the costs of freight and passenger business. 

Whenever such a separation is made, it must needs be on the 
basis of certain physical or financial dimensions of the business 
which are presumably the best index of its responsibility for 
each particular class of costs. For example, there is the ton- 
mile of paying freight, the simplest unit of volume of traffic, but 
so simple that it does not express the dimensions that directly 
control any of the important classes of costs. Then there is 
the ton of paying freight, the best simple index of responsibility 
for the services of loading and unloading. This, of course, would 
be used in this way only for less-than-carload freight, since carload 
freight is loaded and unloaded by the shipper. Then there are 
the number of gross ton-miles (train and contents) for which 

r M. O. Lorenz, Railway Age (March 24, 1923), p. 799. For a criticism of 
the traffic unit see Railway Age (February 24, 1923), pp. 463-66. 


212 


ECONOMICS OF OVERHEAD COSTS 


a given group of shipments is responsible, the number of train- 
miles, the number of locomotive-miles and the number of 
locomotive-ton-miles. The gross ton-mile is a fair index of 
haulage costs, though if it is a question of improving the roadbed 
so that the same locomotives can haul more cars, haulage cost 
per train mile will probably remain nearly constant and the 
increase will take place in maintenance and interest on way 
and structures. 1 This, however, is a special case, calling for 
a special analysis by engineers rather than accountants. 

It would be physically possible to report all these dimensions 
for every shipment, but the cost would be prohibitive. Railroad 
operating men have quite enough entries to make as it is. If all 
this were done, the shipment could be charged with whatever 
part of the total terminal expense corresponds to its net tonnage, 
whatever part of maintenance of way corresponds to the gross 
ton-mileage represented by this shipment, and so on. The 
result would be a figure which might purport to be the “cost” 
of that particular shipment. Though such things as the terminal 
cost of handling unduly large or small packages would still 
remain to be allowed for, this could be done by an extension of 
the plan, after a rough-and-ready fashion. 

Such a figure, however, would be of little use to a railroad. 
A shipment of five tons of soap taken Thursday might “cost” 
twice as much as an identically similar shipment taken Saturday, 
for reasons that were wholly accidental. The road, however, 
must move the soap when it is offered and on the same terms to 
all shippers. They are not interested in accidental variations 

i 

in the cost of particular shipments. So far as these represent 
wastes to be minimized, they will appear in operating records 
of a more general type, recording, for instance, the efficiency 
of train movements without attempting to apportion costs to 
particular shipments. What the managers might reasonably 
wish to know is the cost of all the less-than-carload traffic in 
soap, and in other commodities that move in similar packages 
and volumes and to and from similar classes of terminals. The 

1 The best formula for train resistance is in the form: “So much per car plus 
so much per gross ton.” 


WHAT IS A UNIT OF BUSINESS ? 


213 


records of this shipment, or of the train movement that carries 
it, or of the terminals through which it has passed, ought between 
them to contain raw material from which such a general analysis 
could be made, but these records need not all be borne on the back 
of each single shipment as it moves from origin to destination. 
In this general analysis it would be known about how many 
net tons, gross ton-miles, etc., are chargeable to this traffic, and it 
should be possible to estimate both the average cost and the 
differential cost of that many tons handled at given terminals, 
or of that many gross ton-miles moved over the line under fairly 
representative conditions. Even a few sample studies of this 
sort could yield quite valuable information. 

5. THE SIZE OF THE UNIT OF BUSINESS 

This leads us to another principle under the general question, 
“What is a unit of business?” namely, that costs need not be 
divided and traced to smaller units of business than are involved 
in decisions actually made, rates actually fixed, precedents 
actually determined, etc. The most important unit is a single 
business decision, and whatever volume of business may be 
governed by it. The single shipment of five tons of soap is not a 
business unit in this sense, because nowadays no one ever makes 
a special rate for that much traffic, or initiates any special 
production policy on its account. The smallest unit that could 
be considered is the entire traffic from, say, Zenith to Gopher 
Prairie in soap and any other articles taking the same rate, from 
the time the rate is fixed for as long into the future, virtually, 
as the underlying economic conditions shall continue without 
considerable change. For many purposes the unit would, in 
fact, be far larger. In the largest rate cases the attempt is usually 
made to maintain intact the existing adjustments between places 
and commodities, so far as possible, though question may be 
raised as to rates in one section of the country relative to another, 
or rates on coal or some other major commodity as compared to 
the general level of other rates. Under such circumstances the 
question of differential cost hardly arises at all, the units are so 
large they amount almost to the whole traffic of the road, and it 



214 


ECONOMICS OF OVERHEAD COSTS 


is taken for granted that classes of such magnitude should bear 
their fair share of all overhead burdens. 

Another type of decision arises out of such proposals as that 
for seasonal rates on coal. Here the principal unit in question 
is the traffic in coal in the spring when traffic is regularly lighter 
than in the fall. There is no clear reason why this traffic should 
bear its pro rata share of overhead costs as compared to traffic 
moved during the regular October peak. In fact, there is every 
reason to the contrary, and the decision on this question might 
very well hinge on the differential cost of additional off-season 
business. 

Even where a traffic official is apparently considering a rate 
involving a very small volume of traffic, this appearance may 
be deceptive, because what he does in this case will almost 
surely serve as a precedent for many similar cases, or is itself 
modeled after some such precedent, or is a part of a general 
policy according to which cases of this class are settled. 

One can imagine the situation of the old-time traffic official, 
in the days before the anti-rebate laws, when he was approached 
by shippers each of whom wanted a special rate. If he set his 
minimum at the costs he could trace to each shipper’s business, 
it would frequently be next to nothing. A few carloads a month 
have almost no traceable cost, and might be a gain at almost 
any rate. But let a hundred shippers use the same argument 
and get the same response, and there are several extra trains 
a week and a need for more rolling stock; let a thousand do it 
and there are several extra trains a day, and there will have to 
be new rolling stock, new terminals, and perhaps a rebuilding 
of the main line. So if the road carries one man’s traffic at a 
low rate because its traceable costs are next to nothing it may 
be setting a precedent which will result in a total volume of 
^•traffic costing far more than the rate made. 1 American railroads 
•x have undoubtedly fallen into this trap on occasions, and perhaps 
habitually. 

1 Hadley’s classic oyster case rests for its justification on the fact that a low 
rate would bring in just half a carload of business to fill a half-empty car, and no 
more. This means that it is not typical, because the typical thing is growth, with 
many interruptions, many fluctuations, and no definable limit. 


WHAT IS A UNIT OF BUSINESS ? 


215 


Thus every traffic decision should be treated as a possible 
precedent, and the wise road will avoid setting precedents which 
may become unprofitable by reason of coming to apply to an 
increasing volume of business. A road should not ask whether 
John Doe’s business more than pays the costs visibly traceable 
to it, but whether the low-grade traffic as a whole, or the rebate 
traffic as a whole (in the days of rebates) were worth the cost 
fairly chargeable to it; usually including a reasonable share of 
all the “ constant costs,” not omitting interest on investment. 
For practical purposes, then, the important differential unit oi 
traffic is almost always a large one. Therefore (to return to our 
theme) if the analysis of costs is detailed enough to show the 
differential costs of these large classes of traffic, it is sufficient for 
all requirements. Something similar is true, in differing degree, 
of most other businesses which are above the personal-bargain 
stage of development. Unlike the mathematician, the business 
man seldom concerns himself with infinitesimals—never except as 
incidents in a policy that he deems important. And the econ¬ 
omist can fairly follow his example. 


CHAPTER XI 


THREE METHODS OF ALLOCATING COSTS 

SUMMARY 

The three methods defined, 216—The accounting method, 218—The statistical 
< 0 l hod, 223—The method of operator’s estimate, 227—Conclusion, 231. 

I. THE THREE METHODS DEFINED 

There appear to be three main methods used in dividing up 
the costs of a given concern so as to be able to specify the cost 
of particular items of output. Perhaps, instead of methods, 
these should be called elements of method, because any adequate 
method of tracing costs must necessarily use more than one of 
these elementary methods in order to secure useful results. These 
three elements, then, may be called the accounting method, 
the statistical method, and the method of operator’s estimate 
or engineer’s estimate, with the proviso that these “ methods” 
do not stand alone. A system of cost accounting cannot be 
constructed without using the method of operator’s estimate 
in determining the basis on which to allocate indirect costs, and 
a statistical analysis can hardly be carried out without presup¬ 
posing some use of the accounting method in classifying the data 
which the statistician uses. What these terms mean, then, 
is that certain processes are most prominent and most character¬ 
istic in the work of the accountant and others in the work of 
the statistician or of the expert operator or engineer. 

By the accounting method is meant the system which grows 
out of taking the individual entries of cost (originally gathered 
for purposes of the income account and the balance sheet) and 
charging them against particular items of product. Some can 
be charged directly, because the materials or services they 
represent are physically identified with some unit of product 
in a visible and unmistakable fashion. This is not always quite 
the same as saying that these expenses are economically caused 
by these items of product, as we shall see later, but it is an 


216 


THREE METHODS OF ALLOCATING COSTS 


217 


evidence of one kind of causation, and it is the kind which the 
methods of accounting are capable of recording. When it 
comes to expenses which cannot be identified with units of 
product in this direct fashion, accounting tends to do the thing 
most nearly similar—which may or may not be the next best 
thing—and allocates these “indirect expenses” to one or the 
other department, process, or commodity on some predetermined 
basis. Either of these methods retains one dominant character¬ 
istic of the system of general accounting of which they are an 
offshoot. Costs are built up by a process of arithmetical addi¬ 
tion, and the whole is equal to the sum of its parts. There is 
one qualification, with which we shall have to deal later, which 
may be described by saying that some of the costs are allocated 
as costs of idleness rather than costs of production. Even here, 
however, the system is so managed that the totals will balance. 

Very different from this is the characteristic method of statis¬ 
tical analysis. It is not merely a different method; it yields 
a different kind of information. This method involves observing 
differences in cost which correspond to differences in the volume 
or character of the output. This study may cover the total 
costs of the business as a whole, or the costs of one department, 
one process, or one commodity or class of output. For this 
purpose one observation means nothing, and to make the method 
at all scientific a large number of observations are required. 
For instance, a concern may watch the monthly fluctuations 
of its expenses and compare them with the fluctuations of output, 
in order to learn what the differential cost of added output is. 
Or it may be possible to compare the costs of different establish¬ 
ments some of which are integrated and others of which are not 
(for example, sugar factories which buy their beets and factories 
which raise their own) in order to see how the costs of the two 
methods compare with each other. 

Different from either of these is the method of operator’s 
estimate. This is exemplified in many discussions of railroad 
costs, where it is asserted that two-thirds, let us say, of the 
expenses for maintenance of way are independent of traffic, and 
that half of the expenses of conducting transportation are inde- 


2 l8 


ECONOMICS OF OVERHEAD COSTS 


pendent of traffic. Just what process is involved here is not 
always easy to say, but it is clear that it is something different 
from the formal analysis of the statistician or the arithmetical 
ritual of the accountant. Perhaps it is an intuitive short-cut 
which may involve an implied or unconscious calculation of 
either the statistical or the accounting variety, or a combination 
of both. 

Each of these three methods has both its strong points and 
its limitations. And they need to be used to supplement each 
other in any thoroughgoing analysis of cost. Let us first look 
at the outstanding features of the accounting method. 

2 . THE ACCOUNTING METHOD 

In its origin, accounting is not essentially a method of allocat¬ 
ing costs to goods, but rather of recording them so as to secure 
correct totals, and to make it possible to identify the transactions 
out of which any part of this total outlay arose. The tracing of 
causal responsibility in an economic sense is a more involved 
matter. However, there is one kind of allocation which cannot 
be escaped and is presupposed in any system of accounting 
records, namely, allocating expenses and income to a given period * 
of time. Without this, an income account or a balance sheet 
means nothing. Further, where a business is organized by 
departments, it is useful to allocate expenses to these departments, 
as a help to locating efficiency or waste. For the same purpose 
it is very desirable to isolate the expenses of different processes 
carried on within a given department. When analysis reaches 
this point, it deserves the name of cost accounting, and diverges 
from general accounting, while the tracing of costs to units of 
product is, if anything, even more specialized and differentiated. 
It is a collateral branch of accounting, going into causal analysis 
as general accounting does not, and yet based on the technique 
of the parent stem. It is still cast in the general mold of arith¬ 
metical addition of constituent items, and in form, if not in 
essence, the whole is required to equal the sum of its parts. 

One of the strongest points of this method is that it deals with 
the observed facts of the particular case in hand. Another 


THREE METHODS OF ALLOCATING COSTS 


219 


advantage is that where the sum of the costs of the individual 
items of product equals the whole cost incurred by the establish¬ 
ment, the individual “costs” can be used for purposes of fixing 
prices, with a fair degree of confidence as to the ultimate effect 
on profits. Furthermore, if anything happens to change the 
cost, the accounts will show it promptly, without waiting for 
the results of elaborate statistical studies. 

We have seen that there are two kinds of accounting alloca¬ 
tion, one for direct costs and the other for indirect costs. The 
direct costs are such costs as the materials which go into a partic¬ 
ular finished product and the labor that is actually spent in work¬ 
ing up those particular materials, and no others, into that 
particular product, and no other. A certain amount of leather 
goes into a pair of shoes directly, and a worker spends a certain 
amount of time in the process of sewing together the soles and 
uppers of that particular pair of shoes. Anyone who watches 
the process can see that this labor and these materials are physi¬ 
cally devoted to that product and no other. On the other hand, 
the laborer works with a machine wffich draws its power from a 
shaft to which other machines are also coupled, and the ultimate 
source of the power is a central plant which makes power for 
all the processes in the factory. No one, by merely watching 
the process, can tell how much of the cost of the central power 
station or of watchmen, cleaners, janitors, or legal counsel should 
be charged as the cost of each pair of shoes turned out. These 
are indirect costs, and have to be assigned or allotted on some 
basis other than direct observation. 

This allotting of indirect expenses is a different kind of process 
from that of charging the direct expenses to the product into 
which they go. It involves something more than the mere 
recording and adding up of items. It really involves the method 
of operator’s estimate or expert judgment, and it is something 
which can frequently be helped out and made more accurate 
by the aid of statistics. It involves a judgment as to what 
causes govern the amount of the indirect expenses. For instance, 
in an electrical power station the interest on the investment in 
the company’s central fixed plant does not depend on average 


220 


ECONOMICS OF OVERHEAD COSTS 


output or total output but does depend on the capacity of the 
plant, and this in turn is governed chiefly by the maximum 
demand which the plant must stand ready to meet at any time. 
This expense, if it is to be treated as an expense at all, belongs 
in that group of expenses whose amount is governed by the 
capacity of the plant, and varies with the capacity. These 
are called “ capacity costs/’ They cannot fairly be allocated 
to all customers alike at so much per kilowatt hour, because some 
kilowatt hours bear a heavy responsibility for taxing the capacity 
of the plant, and others bear none at all. 

So a careful system of accounting would find some measure 
of the consumer’s responsibility for increasing the maximum 
demand which the concern must stand ready to meet, and having 
found such a measure it would allocate the “capacity costs” 
to each customer on the basis of the measure of his “peak 
responsibility” which has been adopted. Such a system would 
naturally still stick to the fundamental characteristic of 
accounts: namely, every expense would be allocated somewhere, 
so that the whole would equal the sum of its parts. These 
measures of responsibility for the indirect expenses are necessarily 
rather imperfect things. In some cases, they may be quite 
arbitrary. The difficulty of assigning such an item as interest 
on the fixed investment may furnish one reason why accountants 
so often prefer to exclude interest from costs entirely, but it is 
just as hard to allocate depreciation and maintenance, so that 
this particular difficulty is not removed by eliminating interest. 

One of the unfortunate features of the accounting method 
of analyzing costs lies in the tendency to confuse “fixed charges” 
with “constant costs,” or to assume that fixed charges are neces¬ 
sarily constant costs, so far as they are treated as costs at all. 
This question has already been discussed (chap, ii) and exempli¬ 
fied (chap, ix) so that it need not be reiterated that “fixed charges” 
are a matter of the financial obligations of the company, but 
do not tell how its essential costs of production actually behave. 
As we have seen, with reference to short-run fluctuations of 
output, constant costs are typically much more than the “fixed 
charges,” while with reference to long-run growth of business 


THREE METHODS OF ALLOCATING COSTS 


221 


and plant, there are virtually no constant costs. Capital outlay 
increases, whether “fixed charges” rise or not, and while the 
increase in investment is extremely likely to carry with it a 
harmonious increase in the portion covered by bonded indebted¬ 
ness, this need not happen; and if it does, the increase in fixed 
charges is an incidental and nonessential accompaniment to the 
essential fact of an increase in the sacrifices of production, owing 
to an increase in the capital resources devoted to that purpose. 

This sacrifice is simply impossible to ignore, in any intelligent 
comparison of costs, since it is one of the things which makes 
some commodities more expensive to produce than others or 
some processes of production more economical than other 
processes. The accountant who refuses to admit that interest 
is a cost does not, therefore, judge that every labor-saving device 
is worth installing, regardless of the investment involved: he 
merely translates his inquiry into another form, asking whether 
the saving is a fair return on the investment. As between goods 
requiring much capital and goods requiring little, he asks which 
yields the largest return on the investment concerned. But 
in order to answer this question it is first necessary to allocate 
the investment, charging a definite amount of capital outlay 
against a particular process or a particular commodity. 

Thus the necessity of allocating responsibility for capital 
expenditures is not avoided by refusing to treat interest as a 
cost. There is, however, one thing gained. The allocating 
of responsibility for investment is no longer a matter of accounting 
—a part of the regular procedure of keeping the books—but is a 
broader matter of the study, analysis, and interpretation of 
the accounts and operating records. This frees it, or ought to 
free it, from the trammels of accounting ritual, so that it should 
be possible to treat the matter in any way which any particular 
problem may require. 

There is one thing which the accounting method will never 

» 

tell, and that is whether an increase in the volume of business ^" 

will involve a proportionate increase in the indirect expenses, 
or less, or more. Accounting allocation, when it selects an 
index of responsibility for indirect expenses, virtually takes for 


222 


ECONOMICS OF OVERHEAD COSTS 


granted that these expenses vary in exact proportion to the vari¬ 
ations of this index, whatever it may be. This is usually not 
the case, and therefore the accounting allocation tells no true 
story of the differential costs occasioned by any particular ad¬ 
ditional amount of business. This requires a different tech¬ 
nique altogether. 

Nevertheless, the uses of the accounting system are obvious 
and quite indispensable. It tells the management how its 
costs are behaving, and if there is a suspicious increase in the 
costs, which may be a symptom of a loss of efficiency somewhere, 
the management has the figures recorded in sufficient detail to 
make it possible to tell in what department the increase occurred, 
whether it was in materials or labor, and in what step of the 
process it occurred, or whose machine it was which took an 
unusual amount of time in the completion of the given job. 
The management is accustomed to guide its financial and technical 
policies according to its costs, among other things, and whatever 
methods it uses, right or wrong, logical or illogical, have at least 
stood the test of experience; and in any case, a knowledge of 
what has actually happened is the necessary basis for all intelli¬ 
gent judgment. However, this will not of itself tell the manager 
what his costs will be next week or next month if he follows a 
given policy, and for many purposes he needs to be able to 
prophesy in this fashion. This the accounts, taken by them¬ 
selves, will not enable him to do. 

However, the accounts themselves involve some prophecy. 
Depreciation is essentially a prophetic item. It represents an 
estimate of the present reduction in value of the plant, due to 
the fact that it has fewer years of usefulness ahead of it, and prob¬ 
ably years of diminished uesfulness compared to the years when 
. it was new. This is essentially a prediction, based on past 
experience, and in order to be at all scientific it needs to be based 
upon a thorough statistical study of the life-history of similar 
kinds of machinery and equipment. Thus it appears that 
accounting involves, at certain stages in the calculation and 
allocation of indirect expenses, both the method of operator’s 
estimate and, if it is adequate, the method of statistical analysis. 


THREE METHODS OF ALLOCATING COSTS 


223 


3- THE STATISTICAL METHOD 

Next let us look at the statistical method and see what its 
strong and weak points are. Its advantages and disadvantages 
both center largely around the fact that it studies the behavior 
of total expenses and records whatever it finds. This is an advan¬ 
tage, because it will do the one thing which accounting is least 
able to do, namely, discover whether the differential cost of 
additional business is more or less than the average, and dis¬ 
cover it by studying the actual effects of increased business, not 
by mere conjecture or expert estimate. 

The statistical method furnishes the only valuable evidence 
as to how the “constant costs” really behave. And it is adapt¬ 
able ; it can sample the data in different ways and make different 
tests, throwing light on different kinds of cases. It can study 
fluctuations of any duration: day-to-day, month-to-month, 
or year-to-year; or it can study the long-run economies of large- 
scale production, comparing plants of different size, each of which 
is adjusted to its characteristic range of output. And a statisti¬ 
cian would not be disturbed if each of these tests gave a different 
answer and revealed a different amount of residual cost in each 
case, even in the same industry. The table on page 185 is an 
example of hypothetically simplified statistics and indicates 
how this method is capable of showing a differential cost which 
is high in one case and low in another. A little later, in studying 
railroad costs, we shall see how the actual figures may tell one 
story for short-run fluctuations and a very different story for 
long-run adjustments. And in each case the data make it 
perfectly unmistakable what kind of a case is being tested, so 
that there is no excuse for applying the results of a study of week- 
to-week changes to a decision involving a permanent increase * 
in business, or vice versa. Accounting formulas have not this 
discrimination, and the dicta of expert judgment are too fre-*** ; 
quently presented as universal rules without specifying their 
limitations, and what kinds of cases they apply to. 

The statistical method has a further advantage in that it 
catches everything which expert judgment might overlook, 


224 


ECONOMICS OF OVERHEAD COSTS 


and corrects automatically any possible fallacies due to semi- 
intuitive methods of arriving at conclusions. If the expert 
concludes that half the costs are constant and half variable, he 
may be overlooking the fact that additional business will call 
for additional equipment, or he may be overlooking some econ¬ 
omies in the “variable” expenses of operation. If the “constant 
costs” increase, statistics will show the increase inexorably. 
They will not overlook anything. 

In this last fact lies also a disadvantage, for the statistical 
records catch too much. They show the effects of everything 
that has happened, not merely the effects of the things we wish 
to study but the effects of a multitude of other things which 
are entirely accidental or irrelevant to our particular purposes. 
If we wish to know the effect of increased business on costs, and 
study the changes from month to month with this in view, 
the figures will show all the effects traceable to changes in busi¬ 
ness, but they will also show the increased cost of a strike, of 
heating the buildings through a severe cold snap, of an attack 
of spring fever, or of an accident due to some employee’s over- 
indulgence in home-brew. If we wish to discover the effect of in¬ 
creased traffic on railroad expenses, and for that purpose compare 
a series of railroads, or a series of divisions, some with light 
traffic and some with heavy, the figures will show the whole 
effect of increased traffic on the expenses, including all the items 
which an expert might overlook; but they will also show the 
effect of many other things. One road is located on the 
plains and another in the mountains, one road has to encounter 
blizzards while another is in a warmer climate, one road has a 
well-balanced traffic with nearly equal amounts of east-bound and 
west-bound tonnage, while another road must haul a large per¬ 
centage of empty cars, one road has traffic which is very steady 
throughout the year, while another has to provide for heavy 
seasonal fluctuations. In fact, there is no end to the irrelevant 
circumstances which insist upon recording themselves. 

Two main kinds of comparisons are possible: successive 
observations of the same business unit and simultaneous observa¬ 
tions of different business units; and each one has its own diffi- 


THREE METHODS OF ALLOCATING COSTS 


225 


culties and is complicated by its own peculiar kind of disturbing 
elements, as the foregoing illustrations show. If we study the 
trend of costs from year to year, it becomes necessary to allow v 
for changes in prices and wages, for improvements in technical 
methods of production (which may reduce expenses in ways that 
have nothing to do with the increase in volume of business), and 
other things. These create difficulties, no matter what it is 
the statistician is trying to study. If he is trying to study 
the effect of unbalanced traffic, changes in the total volumes 
of business will be a disturbing element, while if he is studying 
the effects of increased volume of business, changes in the pro¬ 
portion of east-bound to west-bound tonnage will be irrelevant 
to his purpose. 

He can escape some of these disturbances if he shortens his 
period and studies costs of successive months or successive 
weeks, but here a new difficulty arises. For it is hard to deter¬ 
mine just what costs incurred in a given week are due to the 
business of that particular week. As we have already seen, 
maintenance expenses may vary from week to week or from month 
to month without much regard to the wear and tear which the 
business of each week or each month occasions. Therefore, 
before a statistical study can do anything with weekly or monthly 
figures, the accountant must have made a careful allocation in 
order to make sure that the costs reported for a given week really 
belong there. 

Fortunately, this is one of the oldest and most fundamental 
questions with which the general accountant has had to deal, 
so that he has developed methods of meeting this difficulty. 
Before preparing his balance sheet he has to determine what 
costs are properly chargeable against the business of the account¬ 
ing period which has just closed. However, a balance sheet 
is not prepared every month or every week, and the accounts 
do not automatically charge against each week precisely those 
costs occasioned by that week’s business. Hence this kind of 
study may require some special preparatory work on the part 
of the accountants. More particularly when the period is as 
short as a week, the results would come to depend too much on 


226 


ECONOMICS OF OVERHEAD COSTS 


the accountants’ judgment as to what expenses were properly 
chargeable against the business of that particular week, and also 
upon his judgment as to what production should be credited 
to that particular week’s activities. The amount of unfinished 
work on hand may vary considerably, so that it is not a simple 
matter to decide what the output of that particular week is. 
For all these reasons the shortening of the period of study sacri¬ 
fices some of the peculiar benefits resulting from the statistical 
method, and very short periods are extremely unreliable for 
statistical study. 

One question before which the statistical method by itself is 
very nearly useless is the question of the relative cost of different 
types of output. It can tell the cost of a 2 per cent increase of 
business, or a 5 per cent increase, but its measure of volume of 
business is likely to be crude. If it is an automobile factory, 
the natural measure is the number of cars turned out, but it is 
not easy to allow for the difference between a roadster and a 
sedan, and a considerable change in the proportion of cheaper 
to more expensive cars might render the figures quite unreliable 
for purposes of pure statistics. 

It would be possible to attack the problem of the relative 
cost of roadsters and sedans by unaided statistical analysis. 
Or this method might be used to separate the costs of passengers 
and freight. 1 The expenses of different divisions could be 
correlated with differences in the proportions of passengers and 
freight, and a conclusion arrived at as to the relative cost of 
freight and passengers. For this purpose there must be enough 
observations so that irrelevant factors are eliminated by force 
of numbers. Curiously enough, the very thing which was the 
main object of study a moment ago—the effect of volume of 
traffic—is now an irrelevant circumstance, and what was then 
an irrelevant circumstance is now the main object of study. 
The same figures might be used for both purposes, and, if there 
were enough observations, they might tell a credible story in 
both cases. 

*The writer has seen a statement, which he cannot at the moment verify, 
that this has been done by the German railroad economist, W. Launhardt. 


THREE METHODS OF ALLOCATING COSTS 


227 


But the method is awkward, at best, and it is hard to dis¬ 
entangle the disturbing causes sufficiently well to make it con¬ 
vincing. And if one were to try to separate the costs of different 
classes of freight in this way, the attempt would break down of 
its own complexity. In general, other methods must be relied 
upon for separating the costs of different types and classes of 
output from each other. This will usually mean allocating all 
the costs, with the result, as we have seen, that no recognition 
is given to the reduced cost of increased output. But after this 
has been done, if the concern wants to know how much or how 
little effect additional output has on costs, a statistical analysis 
may come to the rescue by showing that differential cost in this 
business, under the given conditions, is equal to about half the 
average cost, or nine-tenths, or what not. Such a supplementary 
study could only speak in approximate terms, but an approxi¬ 
mation is far better than nothing. 

To sum up: The statistical method works under enormous 
handicaps, and yet there are certain things which cannot be 
revealed in any other way and therefore, faulty as it is, it is an 
absolutely indispensable aid to any really comprehensive analysis 
of cost. It is the only method which can give even moderately 
unprejudiced information about differential costs. 

4. THE METHOD OF OPERATOR’S ESTIMATE 

Finally, let us look at the method of operator’s estimate. 
This takes various forms and we shall need to examine several 
types. One excellent example is a study made by Mr. Nimmons, 
a Chicago architect, for the purpose of determining the most 
economical height for an office building in the central business 
district of Chicago. Selecting a given lot he built upon it, 
on paper, six different buildings of heights ranging from five 
stories up to thirty, estimating the total cost of each structure, 
the cost of operating it and maintaining it, and the amount of 
office space available. This might be called hypothetical statis¬ 
tics, but it differs from statistics in not being forced to cover a 
multitude of cases and to include masses of irrelevant data 
in order to sift out the trend of one force. Everything irrelevant 


228 


ECONOMICS OF OVERHEAD COSTS 


is eliminated, and the result is what the experimental scientists 
would call a “controlled experiment”—on paper. The method 
is really the method of hypothetical experiment. It has the 
advantage of eliminating the disturbances to which actual 
statistics are subject, and the disadvantage that its oversights 
are not automatically checked up by the test of actual experi¬ 
ence. 

Another form of operator’s estimate is the one already 
mentioned: the familiar estimate of what percentage of the 
expenses of a railroad are constant and what percentage are 
variable. Just what this means to the person who makes the 
estimate requires a certain amount of imagination to determine, 
for so far as the literal meaning of words goes, the proposition 
that two-thirds of the expenses of a railroad are constant is 
quite ambiguous. How is it mathematically possible for two- 
thirds of the expenses to remain constant and still remain two- 
thirds of the whole, if the rest of the expenses vary ? Or for 
one-third to vary and still remain one-third, if the rest remain 
constant ? 

For instance, in one case Ripley applies this formula to a ten¬ 
fold increase in traffic (a magnitude far beyond its proper range) 
and concludes from it that, if the original costs were ioo, the cost * 
of carrying ten times as much traffic would be 66| (the constant 
component) plus 10X33! (the variable component) or 400 
in all. 1 By the time total expenses reach 400, the constant costs, 
if they really stayed at 66§ (which they could not do) would be 
only one-sixth of the whole, instead of two-thirds. Yet Ripley 
points out elsewhere that constant costs maintain a surprisingly 
steady ratio to variable, as the totals increase from year to year. 
How explain this paradox ? The answer is that, when the plant 
has a given capacity, short-run fluctuations of moderate amount, 
within the limits of that capacity, will cause expenses to vary 
about one-third as much as traffic; while capital investment 
and many other elements of cost will not change at all. 

This clearly takes for granted that the road has not only 
trackage enough to handle any amount of traffic which may be 

1 Ripley, Railroads: Rates and Regulation , pp. 71-73. 


THREE METHODS OF ALLOCATING COSTS 


229 


considered, but cars enough also. Now a road might have tracks 
capable of handling far more traffic than existed, simply because 
it could not have less than a standard-gauge single-track line. 
But if it had cars enough for twice the traffic, even in time of 
depression, the management would be suspected of reckless 
extravagance, if nothing worse. Cars can be built as they are 
needed, and a permanent growth of traffic ought to require 
the building of more cars, the lengthening of sidings, enlarging 
of station buildings, and other additions to the plant, so that 
plant and operating expenses would grow more or less in propor¬ 
tion to each other. Would they grow as fast as traffic or would 
there still be some economy? On that question the formula 
is silent. At any rate, after the plant has expanded to meet 
the needs of traffic, the enlarged plant investment will remain 
unaffected by small, short ups and downs of traffic, within the 
overload capacity of the enlarged plant. In other words, this 
formula applies only to fluctuations of a certain range and period, 
but it does not state what range or what period, and therefore 
it is decidedly ambiguous. 

This defect could be remedied. Instead of merely saying 
that a certain part of the expenses are “ constant,” care should 
always be taken to say that a certain part of the expenses are 
unaffected by such-and-such a change in volume of business. 
For instance, take an increase of business which can be handled 
by increasing the trainload without necessitating the use of more 
powerful locomotives. This would leave most of the train- 
movement expenses unaffected, though it would increase fuel 
consumption moderately, and would call for more rolling stock 
unless it were a short-time increase, confined to an off-peak 
season. On the other hand, an increase which requires an 
increased number of trains will call for more locomotives as well 
as more cars, unless it is confined to an off-peak season, and will 
in any case increase the train-crew expenses about in proportion 
to the increase in traffic. 

Another instance may help to show the need of being specific 
as to what kind of an increase in business the propounder of any 
cost formula has in mind. In one case Ripley assumes that the 


230 


ECONOMICS OF OVERHEAD COSTS 


replacing of ties is due chiefly to weather rather than to use, and 
therefore concludes that it is independent of the volume of busi¬ 
ness. 1 But does this conclusion follow? Grant that the dete¬ 
rioration is due wholly to weather, but suppose also that 
amount of plant exposed to the weather varies with the traffic, in 
the sense that larger traffic requires the road to use more cars 
and lay more tracks in yards and sidings, and therefore to have 
more of them suffering the wear and tear which the elements 
impose. Then this item of cost, which is entirely due to weather, 
is also affected by the volume of business and is, in part at least, 
economically traceable to traffic. The difficulty here is chiefly 
due to a failure to be explicit as to just what kind of a change in 
traffic the maker of the estimate had in mind. 

In this particular case, it is fair to suppose that he had in 
mind such short-run fluctuations of traffic that it would not be 
possible to increase or decrease the investment in rolling stock 
or structures, and therefore the only effect that increased traffic 
could have would be to make the existing equipment deteriorate 
more rapidly. The statement is probably quite correct with 
reference to this particular set of conditions, but it is capable 
of being misunderstood and misapplied because it does not state 
clearly just what kind of conditions it was meant to cover. For 
instance, when Professor Ripley himself later uses this formula 
to calculate the effect of a tenfold increase in traffic, 2 he is, as we 
have just seen, ignoring the fact that no railroad management in 
its senses would furnish cars enough for ten times the existing 
traffic, and unless they did, they could not handle the increase 
without getting more cars, and therefore paying more for the 
repairs which are, in one sense, due solely to weather. 

So far as the general statistics furnish any evidence, they serve 
to indicate that, over a term of years, rolling stock has increased 
about as much as traffic, measured not in number of cars and 
locomotives, but in terms of tonnage capacity and tractive 

1 Ripley, op. cit., pp. 51-52. Ripley does not ignore these facts; on the con¬ 
trary, he gives them very full expression, but he does not harmonize them with 
his percentage formula. 

2 Op. cit., pp. 71-73. 


THREE METHODS OF ALLOCATING COSTS 


*31 

effort. 1 This illustrates the great advantage of the statistical 
method, in that it is nearly always evident from the data them¬ 
selves just what sort of a case they apply to. In this matter the 
method of operator’s estimate is likely to be ambiguous unless 
special care is taken to be specific. 

Another example of operator’s estimate is the one which 
underlies every cost-accounting system at the point where it 
allocates the indirect costs. On what basis shall they be allo¬ 
cated: according to direct costs, direct labor cost, direct labor 
time, machine time, or some other basis? Here the question is 
usually one of finding something which controls the amount of 
these indirect costs, and the test would be that they would vary 
more nearly with this one variable than with any other. In this 
matter the expert’s judgment is likely to represent a combination 
of direct tracing of such things as power expenses to machine 
hours, and of a sort of hypothetical experiment where output and 
costs are varied on paper and the effect of such variations esti¬ 
mated. Any selection that may be made is in the nature of a 
compromise, since some expenses vary more directly with labor 
time, others with direct expenses, others with machine hours, 
and so on. 

But this is not the place for an extended study of the 
technique of cost accounting. The only purpose here is to give 
an idea of the difference between the different ways of analyzing 
cost, the strong and weak points of each, and why they should 
be used together. 

5. CONCLUSION 

The statistical method achieves its greatest possibilities where 
an association of producers, or some research body, can canvass 
a large group of productive units and study the typical behavior 
of their costs. Statistical analyses are so arduous that in order 
to make any very extensive sampling worth its cost, the results 
need to be made available to the trade or industry as a whole. 
On this basis, however, there is room for the making of many 

1 Statistics of numbers only are misleading, because the average capacity has 
been steadily increasing. Such figures are much misused for purposes of propa¬ 
ganda. 


232 


ECONOMICS OF OVERHEAD COSTS 


valuable studies. With these there should go a certain amount 
of analysis of internal statistics by concerns which can afford it. 

The accounting method needs no defense, and will always 
have its place in industry, but cost accounting does need to 
develop greater freedom from the habits and standards of financial 
accounting. Perhaps it may develop into something which will 
not be accounting at all, but rather cost statistics and cost 
analysis. As for the method of operator’s estimate, what it 
chiefly needs is to be more explicit as to its assumptions and 
methods, so that it may not put forth as universal truths 
propositions which are true only of certain limited situations 
and conditions. To repeat: all three elementary methods need 
to be combined in any adequate system of studying and inter¬ 
preting costs. 


CHAPTER XII 





FUNCTIONS AND CHIEF METHODS OF 
COST ACCOUNTING 

SUMMARY 

Introduction, 233—Ten purposes of cost accounting, 234—How can these 
purposes be harmonized ? 244—Direct expenses, 246—Principles governing alloca¬ 
tion of indirect expenses, 249—The “cost of idleness” in cost accounting, 250— 
Allocating overhead among departments, 254—Is interest a cost ? 255—Conclusion, 
257 - 

I. INTRODUCTION 

Cost accounting, as defined by Jordan and Harris, differs 
from general or financial accounting in that while general or 
financial accounting undertakes to show the total profit and loss 
of the business as a whole, the purpose of cost accounting is 
to give detailed information of the cost of a given product, job, 
department, or process, and to analyze this cost into its compo¬ 
nent parts . 1 It is a matter of recording the elements of cost in a 
classified fashion which shall serve to show what parts of the 
business are responsible for them and what different items of 
cost each part of the business is responsible for. This sounds 
as if cost accounting had its scope determined for it by financial 
accounting, its sole business being to analyze the figures which 
financial accounting sees fit to put down as “ costs” for its own 
purposes (chiefly that of showing the total profit and loss of the 
business as a whole). This is only partly true, however. Cost 
accounting has sufficient independence to be in a position to 
include items of cost for its own purposes and then to exclude 
them again for purposes of making up the income account. 

Strictly speaking, “ books of account” are supposed to include 
only items which are destined to find their way into the income 
account and ultimately into the balance sheet, but it is tech¬ 
nically possible to count interest as a cost for cost-accounting 
purposes, and then leave it out for purposes of financial account- 

1 See Jordan and Harris, Cost Accounting , pp. 3-4. 


233 


234 


ECONOMICS OF OVERHEAD COSTS 


ing. We shall see more of this question presently* What, 
then, are the purposes of cost accounting ? 

2 . TEN PURPOSES OF COST ACCOUNTING 

Since the writer is not an accountant, it requires some 
temerity, if not presumption, to discuss the technique of so 
expert a profession. However, he has no intention of discussing 
accounting from a technical standpoint, nor of entering into 
technical details. On the contrary, his purpose is to examine 
the underlying functions which cost accounting appears to per¬ 
form, in the hope that the unconventional standpoint of an out¬ 
sider may be able to throw a useful light upon the question of 
what cost accounting can and cannot be expected to do, and 
what methods are most likely to enable it to fulfil its general 
purposes. 

If there is a central thesis in this discussion it is this: that 
cost accounting has a number of functions, calling for different, 
if not inconsistent, information. As a result, if cost accounting 
sets out, determined to discover what the cost of everything 
is and convinced in advance that there is one figure which can 
be found and which will furnish exactly the information which 
is desired for every possible purpose, it will necessary fail, because 
there is no such figure. If it finds a figure which is right for 
some purposes it must necessarily be wrong for others. The 
conclusion is that cost accounting needs to develop an elastic 
technique of a sort which probably could best be described, 
not as accounting at all, but as cost analysis or cost statistics. 
Accordingly, let us see what the chief purposes of cost accounting 
are. 

These have been summed up under three main uses: to 
enable the concern to set a price that will cover cost and allow 
the desired profit, to eliminate waste in production and to guide 
decisions as to what product should be made. This list, however, 
is too brief and general to give a definite notion of the real task 
of cost accounting and of the kinds of information required of 
it. The guidance of price policy is not a simple thing, and 
requires more than one kind of data, since the relation of prices 


FUNCTIONS AND METHODS OF COST ACCOUNTING 235 


to costs of production is itself quite complex. Indeed, this 
relationship is so obscure and varied that some students of 
the question are inclined to deny that prices are based upon 
costs at all, claiming rather that the concern is governed by 
the market and merely charges what it can get. This is going 
too far, however. The concern always has some discretion, if 
only in deciding to cease carrying certain lines of goods which 
are not worth their cost, and to push others which are more 
profitable. 

A jobbing carpenter and builder does a considerable part of 
his work on what amounts to a cost-plus basis: doing the work 
first and then charging for materials and direct labor, plus a 
percentage for overhead. A retailer commonly bases his prices 
on what the goods have cost him, plus a margin which is none 
too scientifically determined, and frequently governed by custom. 
In some kinds of manufacturing as well as in construction work, 
special jobs of large size are done on contract, and here the pro¬ 
ducer bids on the basis of what he expects his costs will be, 
rather than on the actual costs. If he guesses wrong, he may 
lose. Frequently, however, he runs no risk on the prices of his 
materials, being able to protect himself by securing options if 
he has not the materials in stock. He runs some risk of changes 
in wage-rates, and considerable risk as to the amount of labor-time 
which a given job will require. 

As for manufacturers, they frequently send out price lists 
at the beginning of a season, and thus commit themselves on 
goods they have not yet made, in much the same way in which the 
contractor does, though they retain the power to revise the lists, 
and frequently make minor changes by varying the discounts 
allowed. A price list of this kind is, of course, based on expected 
costs rather than actual, while current changes which may be 
made from time to time are governed, among other things, by 
knowledge of the actual cost of goods already made and in stock. 
Sometimes, when the goods fail to move in a reasonable time, they 
may be disposed of without much reference to their actual cost, 
one of the chief questions being the cost of not selling them, con¬ 
sisting largely of deterioration, storage, and loss of interest. 


236 


ECONOMICS OF OVERHEAD COSTS 


From this brief and inadequate sketch of different types of 
price-making, it appears that while costs is an important fact, 
it figures at least as often in the form of estimates of future 
costs as of records of the costs actually incurred on account of 
the particular goods whose price is being fixed. 

To sum up, the demands made upon cost accounting may be 
roughly catalogued under the following ten functions: (1) to 
help determine a normal or satisfactory price for goods sold; 

(2) to help fix a minimum limit on price-cutting; (3H0 determine 
which goods are most profitable and which are unprofitable; 
(4) to control inventory; (5) to set a value on inventory; (6) to 
test the efficiency of different processes; (7) to test the effi¬ 
ciency of different departments; (8) to detect losses, wastes, and 
pilfering; (9) to separate the “cost of idleness” from the cost 
of producing goods; and (10) to “tie in” with the financial 
accounts. 

Broadly speaking: (1) calls for a knowledge of what we may 
call the total economic sacrifice of production, including interest 
on all investment; (2) calls for a knowledge of differential costs; 

(3) and (4) call for total economic sacrifice, with possible deduc¬ 
tions in special cases; (5) is controversial, some accountants 
including total economic sacrifice, while for certain purposes 
valuation is limited to operating expenses; (6) and (7) again 
call for total economic sacrifice; (8) calls for complete records 
of actual costs and also for standards of efficient performance 
with which to compare them; (9) calls for residual costs 
(total cost less sum of differential costs); and (10) calls for total 
operating expenses, but nothing more. 

From this brief summary certain conclusions are apparent. 
Most of the purposes of cost accounting require statements 
covering the total economic sacrifices of production, but for 
some purposes interest on investment must be subtracted. 
Furthermore, certain purposes appear to call for a knowledge 
of differential and residual costs, and these cannot be found by 
merely subtracting certain items from a set of books which records 
all the economic sacrifices involved. Let us look at these func¬ 
tions a little more in detail 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


i. In helping the management determine normal price, 
cost accounting may take different degrees of responsibility 
upon itself: (a) It may undertake to find the normal price or 
total sacrifice of production and report it to the management as 
the “cost” of the goods. Some of the more progressive cost 
accountants appear to have adopted this as their ideal of what 
cost accounts should do. 1 

b) It may merely report the necessary data out of which the 
management can form its own idea of normal price. These 
would include, at the very least, the direct expenses, divided 
into such parts as would correspond to the units of output on 
which the management might wish to set a separate price; the 
indirect expenses, similarly divided; and finally, if not included 
in indirect expenses, a record of this product’s share in the total 
use of capital equipment. This last would not necessarily 
involve reporting interest as a cost; that whole matter might 
reasonably be left to the discretion of the management, and the 
accounts would still furnish valuable guidance toward making 
an estimate of normal price. 

c) These figures, whether or not they include interest on 
investment, should be capable of being projected as an estimate 
into the future. To do this effectively the past experience of 
the concern should be so organized that it would not only show 
what normal costs would be under normal conditions but allow 
for changes in wages and prices and, to a certain extent, for 
changes in the rate of output. However, there is no need of 
reporting the increase in overhead costs per unit of product which 
results from a decrease in demand, for the effect of this on price 
policy would be pernicious, if it had any effect at all. For it is 
precisely when this element in cost is highest that prices are 
inevitably lowest. However, an increase in direct costs due to 
overtime is a fact worth reporting. To allow for changes in 
wages and prices, normal costs would need to be itemized in 
physical units—so much of a given material at so much per pound; 
so many hours’ labor of a given grade at so much per hour. Then 

1 Cf. C. H. Scovell, Cost Accounting and Burden Application, esp. chap. vii. 


23 8 


ECONOMICS OF OVERHEAD COSTS 


the figures could be corrected by merely substituting new money ' 
values. 

To make perfect allowance for different rates of output 
would require a series of these schedules of normal cost, showing 
cost at different percentages of the full capacity of the plant. 

A .> 

However, much might be done in a far simpler way, by means of 
one schedule of direct costs under normal conditions of operation, 
another schedule of direct costs under an overload, and a “stand¬ 
ard burden rate” for all the indirect expense. This last would 
eliminate the changes in burden per unit of output which result 
merely from the fact that the burden falls upon more units when 
the output is large, and fewer when the output small, since this 
change is irrelevant for purposes of price-fixing. However, the 
burden rate should be itemized sufficiently to show how much 
to allow for any changes in wages or materials entering into the 
indirect expenses. 

2. “Normal price” implies that actual prices will be some¬ 
times above it and sometimes below, and hence arises the further 
need for a minimum below which prices shall not go. The 
fixing of this minimum is perhaps a matter of business policy 

, rather than of accounting, but one of the facts which is most 
pertinent is the differential cost of the goods. Goods sold for 
less than this are surely sold at a loss. Hence a knowledge of 
differential cost is one of the purposes which the cost accounts 
should help to serve. Here, as in the previous case, the informa¬ 
tion may be wanted for goods already produced or as an estimate 
for the future. 

3. Another purpose of cost accounts is to help decide what 
goods to push and what goods, if any, to drop. Ordinarily, 
goods would not be actively pushed unless they were worth 
more than the total sacrifices of production, although an active 
selling campaign might sometimes be undertaken for the purpose 
of utilizing idle capacity, even though the price would not cover 
all the overhead costs. Here again there is need for an estimate 
of differential costs. When it comes to the question of dropping 
some product, there may be some specialized equipment which 
cannot be fully salvaged if the product is discontinued, or the 


FUNCTIONS AND METHODS OF COST ACCOUNTING 239 

equipment may be of a general sort, capable of being used for 
other purposes. In the latter case, the figure for “ normal price” 
would be the gauge of the desirability of continuing the product. 
Where there is some specialized equipment already committed, 
the irrecoverable part of this investment may be deducted as a 
“sunk cost,” but otherwise the calculation is the same. It is 
a problem similar to the last one taken up in chapter ix: the 
problem of abandoning an unsuccessful plant. 

4. The control of inventories involves information as to the 
amount and character of goods on hand, and presumably of the 
cost involved in carrying a given volume of goods, so that the 
concern may choose wisely whether to increase or to reduce its 
inventory. Even the simplest kind of information ought to 
make possible the elimination of a great many crude and obvious 
wastes, but really exact control of inventory requires a knowledge 
of the relative costs of different policies, some involving larger 
inventory and some smaller. In this comparison interest is 
one element, though not always a decisive one. 

5. Another function is the valuation of inventory. The 
mere statement of this function does not convey an adequate 
idea of the dominant purposes which control it. It is at bottom 
bound up with the requirement that no dividends shall be paid 
.which “impair the value of the capital.” This impliedly permits 
the concern to pay dividends if the value of its assets is not 
thereby reduced below the amount set down in the books as a 
capital liability. Evidently the amount the concern can pay 
depends upon the method followed in valuing its assets, especially 
those which change their form rapidly. Any increased value 
which the books set on the assets may, technically, be regarded 
as “earned” and used as a basis for paying dividends. 

This is virtually inevitable, but from it arises a most baffling 
confusion of terms, if not purposes. Costs must help to show the 
managers what the selling value of the goods ought to he. They 
are also used to set forth what the value of unsold goods actually 
is. If the same figure is used for both purposes, the result 
amounts to, assuming that the value is what it “ought to be” 
Moreover, this will produce the same excess of assets over liabili- 


240 


ECONOMICS OF OVERHEAD COSTS 


ties as if the goods were already sold at the price they ought to 
bring. The books will show the same “ undivided profits” 
whether the goods are sold or not. In short, the books will 
show the concern as having already earned a normal return , while 
’^the goods are still waiting to see if the market will take them at 
£ the necessary figure. Thus the company could go ahead and 
pay dividends based on whatever value their goods ought to 
sell for, without waiting to see whether this “ ought” is anything 
more than the substance of things hoped for. In other words, 
when used as a basis for valuing inventory, “cost” becomes 
identical with “income” in its effect on the books. Hence 
accountants often appear to the layman to make no distinction 
between cost and earnings: anything charged as a cost is thereby 
“earned.” 

It is earned only in the sense of being an anticipation of the 
future selling value represented by goods unfinished or unsold, 
being treated as an estimate of the present worth of the prospect 
of selling these goods. This worth might be determined by 
expert appraisal at every dividend date, but it is far simpler to 
adopt a standard, based on cost, which will be on the safe side, 
so that an appraisal would seldom or never result in reducing 
the figure. For this purpose cost, including interest, would not 
furnish the desired margin of safety, so that it appears natural 
that cost without interest should be preferred. 

Another consideration which tends to the same conclusion 
is the desirability of so arranging the accounts that thay will 
show income available for interest or dividends to just the extent 
that goods have been actually sold for more than they cost, no 
more and no less. Any finished transaction, if profitable, should 
furnish a basis for distribution of earnings, and unfinished transac¬ 
tions should not, ordinarily, affect dividend-paying power at all. 
They should neither increase nor diminish it. This proposition 
may not be universally agreed to, under all conditions, but it 
seems to represent customary business policy. 

The system that appears to meet this requirement in the most 
natural way is one that allocates all operating expenses and stops 
there. Then if a concern made goods and did not sell them, its 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


241 


books would show no net earnings, but as soon as it sold any 
goods for more than their share of operating expenses, net earn¬ 
ings would appear. Even so the concern would make a better 
showing than if its unsold goods had not been made at all, 
since in that case it would be out all the constant expenses of 
operation and would have nothing to show for it. Making goods 
to stock increases the showing of income available for dividends 
by just the amount by which the book cost of the goods exceeds 
the differential cost. However, this is not an evil, and since the 
books cannot charge total cost and differential cost both, it 
seems more reasonable to charge total cost. 

This is sufficiently conservative so that both managers and 
creditors may rest assured that there is no reasonable likelihood 
of impairing the capital. In settling this question the decisive 
influence is likely to be the standards of bookkeeping set by 
the banks as a condition of granting credit. They regularly 
insist that cost, as used to value the inventory, shall not include 
interest, or else that any interest so included shall be separately 
stated, so that the banks can make their own allowances. 

6. The sixth purpose of cost accounting is to furnish means 
of testing the economic efficiency of different processes of produc¬ 
tion. There is some question whether this testing is a matter 
which cost accounting alone can be expected to carry out. 
Quite possibly it should be regarded as a task for engineering 
analysis, with the help of the data which the accounts furnish. 
Certain it is that this kind of comparison is meaningless unless 

it takes account of interest on the capital required for each kind u 
of process, regardless of whether the ritual of accounting, as 
developed for other purposes, allows interest to be stated as a 
cost or not. If a process is wasteful of capital, that is just as 
serious as if it were wasteful of labor, and should have just as 
much effect on the costs, at least for this purpose. 

7, Little need be said here of the seventh function of cost 
accounting: that of separating the costs and services of different 
departments in order to show which are most profitable and 
whether any of them are absolutely unprofitable. We shall 
return to this point presently. The question takes one form 


242 


ECONOMICS OF OVERHEAD COSTS 


where each of the several departments sells its own class of 
product, and a different form where the departments carry on 
successive stages of a productive process, and only the final 
department actually does any selling and produces any direct 
income. In either case, however, it involves an estimate of sacri¬ 
fice on account of investment. 

8. Another function is to detect losses, wastes, and pilfering. 
Here the important thing is to keep a complete record of all 
transactions so that materials and services cannot disappear 
without leaving gaps in the records. Aside from this, however, 
it is extremely useful to set standards of performance, with which 
the actual performance can be compared and by which it can 
be judged. Wherever standards of this sort are set up, there is 
likely to be an irresistible pressure to use them as incentives 
to increase efficiency; in other words, to set them a little higher 
than the records actually achieved. That is, standards of per¬ 
formance tend to be set higher and standards of cost tend to be 
correspondingly lower. These standards, however, are not part 
of the cost accounts themselves, except in one case, namely, the 
standard burden rate, which belongs under the next topic. 

9. The ninth purpose of cost accounting is to measure the 
waste of idle time and separate it from the cost of producing 
goods, in order that cost of production shall not be unreasonably 
swollen by including what is essentially a cost of idleness. There 
are probably two salient evils which this proposition has in view 
and against which it is aimed. One is the fact that the cost of pro¬ 
duction in the shop or factory is at the mercy of the volume of 
sales and furnishes no reasonable test of the real efficiency of 
the factory organization, if efficiency means meritorious per¬ 
formance, unless the increases and decreases due to the changing 
volume of sales can be eliminated. Another evil is the absurdity 
arising from the fact that costs are highest when demand is 
lowest, merely on account of the fact that the indirect expenses 
do not shrink as fast as output and therefore fall as a heavier 
burden on each unit of output in dull times. But if costs mean 
anything as a guide to price policy, then it is absurd that they 
should go up at just the time when prices need to come down. 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


243 


Moreover (and this fact is not always perceived) it does not 
cost any more to add ten units to your output when you are 
working at half capacity than it does when you are working 
at full capacity; in fact it very probably costs less. This means 
that ten added units at the same price will yield just as large 
a differential profit when the plant is working at half capacity 
as when it is working full—that is, just as large an increase in 
the net assets of the concern above what they would have been 
if the sales had not been made. 

10. One further requirement might be mentioned, namely, 
that costs as reported in the cost accounts shall agree with costs 
as set down in the general books from which the income account 
and the balance sheet are made up. This is not absolutely 
necessary, but is extremely convenient, and furnishes a valuable 
check. And yet, as we have already seen, if cost accounting 
includes interest, it must be excluded again before making up 
the income account. So far as operating expenses go, the cost 
accounts can be made to check with the general books, but they 
need to be free on particular occasions and for particular purposes 
to do something more than this. 

Wherever the cost accountant uses a standard or normal 
burden rate instead of the actual burden, this agreement between 
cost accounts and financial accounts becomes purely nominal. 
The sum of the actual financial costs of the business is one thing, 
the sum of the cost-accounting “costs” of the different products 
(including the “normal” burden, not the actual) is a different 
thing, and the books are balanced by setting down the discrep¬ 
ancy as a discrepancy, calling it “unabsorbed burden” or “over¬ 
absorbed burden” as the case may be. The wide differences of 
opinion as to how this discrepancy should be treated are evidence 
that the tying together of these two kinds of costs is a union 
of two essentially different things. 

There is another requirement, or general presumption, under 
which cost accounting lies. This consists of a widespread and 
deeply rooted habit of thought among business men to the effect 
that prices must necessarily more than cover costs, and that a 
price below cost is an economic absurdity, or at least a very 


244 


ECONOMICS OF OVERHEAD COSTS 


exceptional circumstance. This may be called a prejudice or a 
custom, though we have seen that it has a certain logical connec¬ 
tion with another custom: that of valuing unsold goods “at 
cost.” In either case cost must be less than “normal price.” 
The costs which go on whether goods sell or not need not be 
covered in dull times; in fact, they generally cannot be covered 
in full. 

There are times when it pays to sell some goods, at least, 
for anything they will bring over and above the differential 
cost of producing them rather than not producing them. Thus 
if cost accounting set out to be utterly and absolutely con¬ 
servative, it would have to confine itself to the differential cost of 
the goods. But aside from the fact that this could not be made 
a matter of accounting record, it is carrying conservatism need¬ 
lessly far. A “cost” based on the general policy of allocating 
all operating expenses is conservative enough to satisfy the 
business man’s sense of fitness in this regard, and avoids adding 
one more to the array of conflicting notions of cost which have 
to be dealt with. 

3. HOW CAN THESE PURPOSES BE HARMONIZED ? 

To sum up this survey of the different kinds of information 
required of cost accounting, it would seem to include some four 
things. First are the direct expenses of each job. Second is a 
fair share of indirect expenses, allocated to each job. These 
two sets of figures can be treated as an integral part of the 
“books” from which the income account and the balance sheet 
are made up. Third come estimates of total sacrifice of produc¬ 
tion, including interest on the entire investment, and all other 
overhead charges. These may be modified so as to take the 
form merely of allotting responsibility for a given amount of 
use of investment, leaving the management to translate this into 
a money charge on the goods. And fourth comes a varied 
assortment of comparative studies of cost, including cost at 
different rates of output, cost with or without certain processes 
or departments, etc., all leading to various sorts of differential 
cost. The first two requirements do not give much trouble, 



FUNCTIONS AND METHODS OF COST ACCOUNTING 


245 


since such items as interest on investment may be included in 
the books and used when desired, or excluded from any state¬ 
ments for which they are not wanted. Or they may be excluded 
from the formal books of account altogether, and relegated to 
the field of special cost studies for special purposes. All this 
presupposes that the manager will have sufficient command over 
the cost figures, and sufficient understanding of them, to make 
them his servant and not his master. 

The chief difficulty arises in the case of differential costs. 
As we have seen already, more than once, differential cost 
means a great many things and is something which the books 
alone cannot show. In the problem which was studied in 
chapter ix, the differential cost of additional output varied 
from $509 to nearly $1,300 according to circumstance, and if 
it had been a question of finding out the differential cost 
of one particular class of products as over against another 
class, this answer would have been different from any of the 
others. 

However, in this particular case differential cost was found 
to move in fairly close harmony with the direct expenses of 
operation throughout the medium ranges of fluctuation, and in 
most businesses something like this is likely to be the case. 
And since no one expects a cost-accounting system to do more 
than furnish aids to the manager’s judgment—it is certainly not 
supposed to settle all problems in advance and render the 
manager’s judgment superfluous—the mere recording of direct 
expenses of operation will give the management a useful basis 
from which to judge what the differential costs are in any given 
case. His own experience should enable him to tell in a general 
way under what conditions to expect the differential cost to be 
more than the direct operating expenses or less. However, the 
manager’s unorganized experience can be vastly helped toward 
exactness if he has the benefit of some organized statistical 
analysis of sample cases. 

Let us now look for a few moments at each of the three 
chief constituents of costs: direct expenses, indirect expenses, 
and interest, from the standpoint of cost accounting. 


246 


ECONOMICS OF OVERHEAD COSTS 


4. DIRECT EXPENSES 

It seems perfectly obvious at first sight that the direct 
expenses are economically traceable to just those products into 
which the materials and labor in question can be seen to dis¬ 
appear. For most purposes this is true, but there are some 
exceptions. When a concern is working full time and then takes 
on some extra work this may require paying labor a premium 
above the usual rate per hour or per piece, for the overtime. 
Then the cost of these last and most expensive hours of work is 
properly chargeable against the emergency orders which made 
the overtime necessary. If the men happen to be working on 
these extra orders during just these extra hours, then the direct 
expense would be a satisfactory record of the cost really due to 
this emergency work. But it is much more likely that they will 
work, say, the first five days of the week on their regular orders 
and all day Saturday on the emergency work, so that they will 
be devoting overtime hours from Monday to Friday to the 
ordinary work of the concern and the emergency work will be 
done, in large part at least, during regular hours and at regular 
rates of pay, so that it would not be charged with all the over¬ 
time which it made necessary. 

Here the direct method of tracing costs is clearly no index 
to the economic responsibility which goods bear, nor of the cost 
caused by particular jobs or particular orders. The usual 
practice with regard to this is to distribute the overhead over 
all the work, so that it all shares alike regardless at what hour 
of the day a given job happens to be performed. This eliminates 
the most obvious element of pure chance from the calculations of 
cost, but it results in charging the emergency work with con¬ 
siderably less than the direct cost which it actually occasions. 
If this emergency work does not pay for all the overtime, includ¬ 
ing what is charged to other jobs as well as what is charged to it, 
it will not pay for itself. 

Thus we see that there are questions of allocation, even in 
the case of direct costs. Even the regular procedure of cost 
accounting does not accept the fact that costs are directly 
devoted to a certain thing as a conclusive reason why they 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


247 


should be charged to that particular thing. In fact, in the case 
of overtime, it deliberately redistributes them. And this makes 
the direct costs a very poor index of differential cost of added 
business whenever overtime pay is involved. If the costs are 
to be kept in this way, the management should certainly be on 
its guard against taking emergency orders on the assumption 
that they cost no more than the books show. However, this is 
perhaps an academic issue, since a concern whose services are 
so much in demand is fairly sure to be making a good profit, 
at least on any new business which it takes. And in such cases, 
a nice attention to exact accuracy in the matter of differential 
cost is probably quite unnecessary. 

Another interesting fact in connection with this problem is 
that if the concern could get rid of any part of its existing busi¬ 
ness, either the new orders which precipitated the overtime or 
the old orders which occupied its normal capacity, in either case 
the cost it would save would be the overtime cost. From this 
point of view the overtime is chargeable not merely to the new 
business but to the old business also. That is, if eight hours is 
the standard day and overtime is charged at 50 per cent above 
the standard rate, then when the concern is working nine hours 
a day one might say that any and all of its work is costing 50 
per cent more than usual for direct labor. The one hour of 
overtime costs the concern, let us assume, 90 cents instead of 
60, so that its expenses are increased by a total of 30 cents. 
But at the same time the cost attributable to the goods turned 
out has gone up, not 30 cents but nine times 30 cents, because 
if the concern could get rid of any hour’s work, no matter whether 
it were the first hour or the last, they would save 90 cents. 

From the standpoint of accounting this is an obvious absurd¬ 
ity, because the sum of the direct expenses of all the different 
jobs cannot be more than the total amount which the concern 
has to pay. But from the standpoint of tracing economic 
responsibility it is the plainest of common sense. Thus the 
requirements of the books of account and the requirements of a 
true economic analysis of causal responsibility for expenses may 
contradict each other. 


248 


ECONOMICS OF OVERHEAD COSTS 


In practice, the situation is often complicated by the fact 
that the regular business is produced under contract, so that the 
concern is not free to drop it when the emergency business comes 
up. Under such conditions there would be no particular logic 
in insisting that the regular business was responsible for all 
the overtime, and chargeable with the full amount the company 
could save by going back on their contracts and giving precedence 
to new orders. In such a case the really important calculation of 
cost, so far as the contract orders were concerned, was made 
when the contract was entered into. At that time the concern 
should have made an estimate of what its costs were likely to be 
during the life of the agreement. This would mean an average 
of the various possible conditions the concern might reasonably 
expect to prevail: so many weeks at part capacity, so many 
weeks at full capacity, and so many weeks under overtime 
pressure. Wherever this is the case it does not make any 
difference how the direct costs may be figured later on, except 
as it may have some effect in influencing the concern’s judgment 
as to whether their contract has turned out advantageously or not. 
For this purpose the regular accounting method is slightly mis¬ 
leading but probably not sufficiently so to produce serious results. 

Much the same question arises when the concern has on 
hand materials bought at different times and at different prices. 
Such differences are not relevant to the present cost of producing 
goods. One solution is to charge the materials at the market 
price prevailing at the time they are used. This is the most 
reasonable measure of the present sacrifice involved in putting 
these materials in the form of a product for sale. Then if the 
materials have gone up in price since they were bought, that will 
appear in the books as a speculative profit on holding the mate¬ 
rials, not as a manufacturing profit on working them up. In the 
same way, when prices of materials have gone down, the loss 
will appear as a speculative loss on holding the materials, not as 
a manufacturing loss on producing the goods. 

We have already noted the case of a concern which lost con¬ 
tracts through charging materials at actual cost, after the 
market had suffered a heavy fall, so that their competitors 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


249 


could get the advantage of much cheaper materials. 1 The 
concern had lost money on its materials, and their system of 
accounting led to recording that loss when they used the materials 
in a given piece of work, so that it appeared as a loss on that 
work (or as a lessening of the profit). But this put the responsi¬ 
bility in the wrong place. The loss was not due to working up 
the materials, but to having held them in stock while their 
value fell. This loss would not be lessened by insisting that the 
materials should be worked up only where it could be done at a 
price that would make good the shrinkage. That would merely 
lead to greater losses through reducing the volume of business, 
and postponing the time when they would buy new materials 
at the lower market prices and begin working them up at their 
usual rates of profit. 

5. PRINCIPLES GOVERNING ALLOCATION OF INDIRECT 

EXPENSES 

Indirect expenses are allocated to particular jobs on three 
principal bases. They are divided according to the number of 
direct labor hours, the direct labor costs, or by means of a 
“machine rate,” a charge more or less in the nature of a rental 
for the use of a given machine or other unit of productive equip¬ 
ment. The machine rate may or may not include interest on the 
cost of the equipment, but it is, in any case, charged to the goods 
on the basis of the time during which they make use of this 
particular machine or “production center.” This means that 
whenever a job is going through the shop or factory, the records 
which it carries with it must include not merely the materials 
used (so identified that their cost can be ascertained and charged 
against the job) and the amount of direct labor performed, so 
that the cost of this labor can be charged against the job, but 
also the time during which it was being worked on in any given 
production center, so that the proper rate of burden may be 
charged. 

There is much dispute as to which is the best basis for allocat¬ 
ing burden, or whether one basis should be used for some parts 


1 See chapter ix, sec. 9, above. 


250 


ECONOMICS OF OVERHEAD COSTS 


of the burden and another basis for other parts. Into the details 
of this discussion there is no need of entering here. The assump¬ 
tions underlying the argument seem to be that burden varies 
approximately with one or the other of these indexes and that 
it is desirable to find the index which furnishes the best gauge 
of its variations, providing this can be done without too much 
trouble and cost in the work of accounting itself. This assump¬ 
tion that burden varies with some dimension or other of output 
needs some explaining in order to square it with the assumption 
underlying much of the discussion of “standard burden rates,” 
namely, that burden is largely independent of output, so that 
the cost per unit grows heavier when the output decreases and 
lighter when output increases. The explanation is that burden 
is not absolutely unresponsive, but relatively so, and also that 
it is far more responsive to long-run movements than to short-run 
fluctuations. 

6 . THE “COST OF IDLENESS” IN COST ACCOUNTING 

This subject cannot be better introduced than by some 
passages from an article by Mr. H. L. Gantt: 1 “In but few 
[manufacturing plants] are the machines and equipment in 
active use more than half the working time.” The reasons for 
this can be mostly summed up under such causes as lack of 
orders, lack of material to fill orders received, lack of labor, and 
machinery out of order. The cost system which loads all the 
expense of the plant upon the product turned out is coming to 
be regarded by accountants as fundamentally wrong: 

putting on the product of one machine the expense of maintaining in idle¬ 
ness another machine which does not in any way influence the product. 
.... In our first attempt to find out whether we can afford to take an 
order or not, we must find out what expense we should be under for main¬ 
taining our equipment in idleness, if we did not take the order: for it is 
perfectly well understood by all thinkers on the subject that idle machinery 
is idle capital on which we lose not only the interest but the taxes and insur¬ 
ance on the machinery as well. If failing to take an order would cause 
idleness of machinery and equipment, we should incur an expense if we did 

1 See the Annals of the American Academy of Political and Social Science 
(1919), p. 258. 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


not take it; moreover, we should lose a part of our organization .... if 
we took the order at a loss equivalent to that caused by the above-mentioned 
idleness we should still be ahead, for we should not lose our organization 
.... we should be in a better position than our competitor who did not 
take a similar order . 1 

Here we have an unusually forcible expression of the essential 
problem of idleness and constant costs, implying clearly that 
business is worth taking at anything more than its differential 
cost. The natural conclusion would be that nothing but differ¬ 
ential costs should be charged against the product, and all the 
residual costs should be left undistributed. As we have already 
seen, no accounting system can do just this; hence it will be 
extremely interesting to see what happens to an accounting 
system which tries to do it, and what sort of a working approxima¬ 
tion is forthcoming. 

Even if an accounting system could isolate those indirect 
expenses which remain constant as output varies, the result 
would not be the sort of thing suggested by the phrase: “cost of 
idleness.” It would be, rather, the cost which is neither cost of 
production nor of idleness but of readiness to produce, regardless 
whether there is any production or not. If the purpose of the 
accountant is to isolate the cost of idleness as such, he will not 
naturally charge it with all the constant costs. 

A hint to this same effect is contained in the suggestion that 
the causes of idleness are things for which management is respon¬ 
sible and over which it has control. This looks toward finding 
a quantity which would serve as an index of the efficiency with 
which management performs its task of eliminating idleness: 
something that would increase as idleness increased and vice 
versa, or in some other way serve as a barometer. Constant 
costs obviously would not do this: they represent capacity 
regardless of use or non-use. Evidently it is the unexploited 
portion of the constant costs which the accountant is bound to 
select in his quest for an index of managerial efficiency. 

In setting up indexes of efficiency in general, a standard is 
set and actual performance compared with it. This is sub- 


1 Ibid., p. 259. 


252 ECONOMICS OF OVERHEAD COSTS 

stantially what the “standard burden rate” does. It selects a 
“ standard” output and estimates the total burden which that 
output should occasion, and finds the resulting burden per 
unit of the standard output. This gives a standard or normal 
burden, which can be allocated on any desired basis, with the 
result that product is charged with normal burden per unit, 
rather than with actual burden. 

The nature of this standard or normal is a subject of much 
debate among accountants, some thinking of it as an average of a 
term of years, and others as representing the best possible 
performance. 1 In any case, the sum of the “costs” charged 
to the different items of product will differ from the actual costs 
of the concern for the same period, partly because the actual 
total burden will differ from the estimated normal total and 
partly because the number of units on which the standard 
burden is charged will be less or more than the estimated normal 
number. Other things being equal, if output is less than “ stand¬ 
ard,” the sum of the “costs” of the different units of product 
will fall short of covering the total burden, and there will be a 
discrepancy designated as “unearned burden” or, better, as “un¬ 
absorbed burden,” since the term “unearned” is confusing in 
this connection, having nothing to do with earnings actually 
received from sales. And if output is more than standard, 
then, other things being equal, the total burden charged against 
the goods will exceed the burden actually incurred, and the 
discrepancy will be of the general nature of a profit from full 
utilization. 2 This unabsorbed cost, or this “profit,” furnishes 
the accountant’s index of the “cost of idleness,” though of course 
its meaning is wholly relative and depends entirely on the nature 
of the standard selected as normal. If performance exceeds the 
standard, the “cost of idleness” is a minus quantity. 

But while it is fairly clear what “cost of idleness” means 
under this system, it is not by any means clear what the “cost 
of producing goods” means. It consists of direct costs actually 

1 See discussion in Year-Book of the National Association of Cost Accountants , 
1921. 

a It is a “profit” in the sense that the book value of the inventory, at “cost,” 
includes more than the costs actually incurred. 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


expended, plus indirect costs at the normal rate. Goods are 
still charged with the costs which would go on just the same 
whether the goods were produced or not, and if business is 
turned away because it will not pay its “cost,” then the ideal 
expressed by Mr. Gantt is not lived up to. However, what 
Mr. Gantt apparently presupposes is that the management will 
not insist rigidly that every sale must cover the cost of producing 
the goods, but merely that it must at least cover the excess of 
the cost of producing them over the cost of the idleness that would 
result from not producing them. 

The cost of production includes direct expenses plus normal 
burden. The cost of non-production includes the same normal 
burden, which would be added to the “unearned” or “un¬ 
absorbed” burden if the goods were not produced. Thus the 
two burdens cancel and the goods are worth producing if they 
cover their direct cost. This would be quite correct if direct 
costs varied exactly in proportion to output and indirect costs 
were wholly constant. For short-run purposes this is probably 
as good a rough approximation as is available. Thus goods do 
not have to be worth their “cost of production” to be worth 
producing, though it is more than doubtful if many managers 
interpret the figures for standard burden in this way. 

What, then, does the “cost of producing goods” mean under 
this system? In terms of the practical results, it means two 
things. The costs charged to specific items of product absorb 
substantially all the operating expenses (at least over a term of 
years), while avoiding the absurdity resulting from the fact that 
costs per unit rise when business falls off and vice versa, owing to 
the behavior of the constant operating expenses. Both of these 
considerations have strong practical arguments in their favor, and 
there is no need to reiterate them or enlarge upon them here. 
It is evident, however, that in order to fulfil its final practical 
function and prevent a concern from refusing business which 
would be worth its differential cost, the “standard burden” 
system of costs needs to be applied with some boldness by a 
manager who is not afraid, on occasion and for sufficient reason, 
to sell goods at less than “cost,” as the books show it. 


254 


ECONOMICS OF OVERHEAD COSTS 


It is beyond the province of the present writer to criticize 
the principle of the standard burden rate as an accounting device. 
What has been said indicates its appropriateness to certain of the 
purposes which govern accounting. It undoubtedly serves 
certain useful functions. What the present study is competent 
to point out is that the “cost of production” resulting is not 
actual cost, average cost, normal cost nor differential nor marginal 
cost. It is actual direct cost plus “normal” indirect cost: 
a compromise which must be appraised according to its results. 

Some advocates suggest that the use of “standard burden” 
will help materially to settle the unrest of labor by establishing 
the principle that capital is not entitled to earnings unless it is 
actually employed. This claim seems unduly pretentious. In 
the first place, the normal rate is usually set so as to allow for a 
certain amount of idleness on the part of the capital equipment. 
In the second place, even if there is a balance of unabsorbed 
burden, there is nothing to prevent profits on sales being high 
enough to cover it—nothing in the accounting system, that is, for 
this is a matter entirely of what the market will afford. In 
the third place, the standard burden rate is not exactly a simple 
thing, in all its bearings and operations, and labor distrust will 
not easily be resolved by anything which complicates, rather than 
simplifies, the statement of profit and loss. 

7. ALLOCATING OVERHEAD AMONG DEPARTMENTS 

So far as manufacturing is concerned, the allocating of 
overhead among departments raises few serious problems. The 
equipment located in each department can be identified and 
separately valued, costs of power can be distributed according to 
amounts of power actually used, costs of the building can be 
distributed on the basis of space occupied, since there is generally 
no sufficient reason for reckoning one space more costly or more 
valuable than another, and the questions remaining are chiefly 
those of allotting a share in space or facilities used in common. 

In large mercantile establishments, such as department 
stores, some complications arise, because the departments are 
mostly selling goods and each must show a profit, while a great 


FUNCTIONS AND METHODS OF COST ACCOUNTING 


deal may hinge on the space used by each department, both in 
the store and in the show windows. The usual method is to 
estimate the relative values of different spaces and apportion 
the costs of the building to the different departments according 
to the amount and kind of space used, so that if a department is to 
get the benefit of a week’s use of the most prominent show 
window, or an increased amount of the most valuable inside 
space, it must have the value of this space added to its depart¬ 
mental costs, and must show earnings enough to cover it. A 
rival theory maintains that there is no absolute “best” or 
“worst” space, but that in a properly arranged store there is 
one appropriate and correct place for every line of goods, that the 
best place for jewelry is not the best place for sporting goods, etc., 
and that therefore there is no need for making any difference in 
charge as between ground floor and upper floors. This conten¬ 
tion appears to be only partially borne out, however, and the 
method of allocation of costs according to estimated worth of 
space seems to be firmly established. 

8 . IS INTEREST A COST? 

The foregoing discussion may serve to throw some light on 
the time-honored dispute whether interest is a cost of production. 
The discussion of this question is a strange mixture of dogmatic 
assertion and arguments from expediency, based on assumptions 
as to how a given policy would work. With some of the more 
moderate disputants, however, the issue appears to reduce itself 
to the question whether interest shall be charged in the formal 
books of account, or kept track of in a separate set of records 
and used whenever questions arise which require it. This degree 
of tolerance is. a hopeful sign. From the standpoint of this 
study either system might serve all essential purposes. 

Books which do not include interest are primarily adapted to 
the purposes of financial accounting, and cost accounting, or 
cost analysis, would in such a case be forced to the keeping of 
interest in supplementary records. Books which include interest 
are primarily adapted to the purposes of cost accounting, and 
the interest must be subtracted in making up the income account. 


256 


ECONOMICS OF OVERHEAD COSTS 


In either case there must be studies and analyses of cost which are 
not part of the books of account and need not be bound by any 
of their standards of procedure In cases where the books 
exclude interest, and are thus adapted to financial rather than 
cost-accounting purposes, cost accounting might cease to have 
the distinctive character of accounting at all, and might become 
wholly merged in this broader and more elastic technique of 
“cost analysis.” As between charging interest as a cost, and 
not charging it, the best system is probably the one which best 
promotes the development of this independent and untrammeled 
study of costs, and tends most to make accounting outgrow the 
attitude that cost is one thing for all purposes. 

If the fundamental strategy of price policy comes to be gov¬ 
erned by cost analysis rather than by accounting, then those who 
are interested in preventing cut-throat competition would not 
need to insist that the books of account should include interest 
as a cost, while those who are interested in the policy of free 
cutting of prices when necessary to utilize unused capacity would 
not need to oppose the inclusion of interest as a cost. 

The argument on this issue runs the gamut of all the functions 
of accounting, each side emphasizing those which best support 
its case. The argument even reaches into the question of rela¬ 
tions to labor and to the public, some holding that these relations 
would be improved by limiting the area of dispute to the return 
above interest—the “net profit” in the language of the economist. 
Others fear that if this were done there would be a tendency to 
claim all of this “net profit” for labor or the public, whereas 
they hold that the concern needs some surplus earnings of this 
character in order to induce capital and enterprise to take the 
risks involved. This appears to be a. matter of judgment on 
which the principles of overhead costs can throw little light. 
The issue seems a somewhat forced one. What labor or the pub¬ 
lic sees is the income account, not the individual cost charges to 
particular goods, and the income account does not naturally 
show interest as a cost. It seems doubtful if a technical matter 
of accounting can have far-reaching effects upon the deep 
currents of public sentiment and opinion. 


FUNCTIONS AND METHODS OF COST ACCOUNTING 257 


9. CONCLUSION 

Little more need be added by way of pointing the general 
moral of this very inadequate survey. It is apparent throughout 
that the purposes of cost analysis require a number of different 
conceptions and measures of cost, and the natural result is a 
plea for the development of a sufficiently varied technique to 
satisfy these quite independent requirements. The writer has 
little disposition to interpose in accounting controversies or to 
criticize the prevailing methods of accounting from the point of 
view of the main purpose of financial accountancy , which he takes 
to be the construction of an income account and a balance 
sheet. But he would insist strenuously that other conceptions of 
cost and profit must, somehow and somewhere, find adequate 
recognition and scientific treatment. 


1 


CHAPTER XIII 

RAILROADS AND COSTS: A STATISTICAL STUDY 

SUMMARY 

Introduction, 258—Long-run trends, 260—Lorenz’ comparison of different 
roads, 265—A case of daily fluctuations, 270—The seasonal cycle of traffic and 
costs, 273. 

I. INTRODUCTION 

Railroads have long been held up as a typical example of a 
business of large overhead costs, where “constant costs” absorb 
an abnormally large percentage of income. This is, in general, 
true, though some other industries, particularly public utilities, 
show an even larger percentage of investment to annual output. 
In this respect an automatic telephone exchange is probably 
entitled to first rank. As for manufacturing industries, they are 
not strictly comparable unless one uses the figures for “value 
added to materials” and ignores the cost of the materials that go 
into their products. The usual method of describing the behavior 
of railroad expenses is exemplified by Ripley’s formula, which 
says that about half the operating expenses are constant and half 
variable 1 wdiile taxes and return on investment are regarded as 
wholly constant. Since these last two items absorbed, at 
the time of which Ripley wrote, about one-third of every dollar 
earned, the upshot was that two-thirds of railroads’ costs were 
counted as constant and one-third variable. 

Combined with this, however, goes a clear recognition of the 
fact that the “constant costs” grow with the growth of traffic. 
Ripley show r s that they have grown, over a term of years, sub¬ 
stantially as fast as variable costs. Indeed, this is implied in his 
very assertion that constant costs remain persistently about two- 
thirds of the whole. They could not do this unless they increased 

1 Ripley in his Railroads: Rates and Regulation, chap, ii, develops this formula 
on a basis of “expert estimate” and also presents a considerable amount of statistical 
evidence as to the behavior of costs, none of which, however, supports this particular 
formula. 

258 


RAILROADS AND COSTS 


259 


substantially as fast as “variable costs.” As we have seen, it is a 
mathematical impossibility for constant costs to remain constant 
and also remain two-thirds of the whole, if the rest of the costs 
vary. 

What this means is that certain kinds of variations in traffic, 
limited in amount and duration , do not affect the capital invest¬ 
ment at all, while their effect on operating expenses is as if half 
of them varied in proportion to traffic and half remained constant. 
If the traffic offered for shipment increases beyond what the exist¬ 
ing trackage and rolling-stock can handle, the result is congestion. 
Freight moves slowly, deliveries are delayed, and there comes a 
point beyond which the increase simply cannot be handled. In 
the meantime, “variable expenses” increase faster than the vol¬ 
ume of service actually rendered to traffic. 

On the other hand, the growth of traffic from year to year calls 
for more equipment, while many elements of operating expense 
which remained constant before now tend to increase. In short, 
the tw T o kinds of variation produce totally different sorts of 
changes in costs. 

In fact, there are quite a large number of different types of 
change which need to be distinguished in any discriminating 
analysis. There are very brief ups and downs—daily, weekly, or 
monthly. Here there is little or no chance to increase the physi¬ 
cal plant, so that business cannot increase beyond its extreme 
capacity on account of congestion and inability to move the 
increased tonnage. Thus the fluctuations are automatically 
limited to a range within the capacity of the existing facilities. 
A single road, to be sure, can borrow cars from other roads, 
provided they have them to spare, but the roads as a whole 
could not increase their rolling-stock by borrowing from each 
other. Operating expenses will vary with the volume of business, 
but daily changes may affect them quite differently from monthly 
or seasonal fluctuations. 

As for the more permanent yearly growth; if slight, it may at 
certain stages involve an increase in rolling-stock only; soon, 
however, it will call for more yard-tracks, sidings, and station- 
capacity; further, it may make it economical to improve the 


26 o 


ECONOMICS OF OVERHEAD COSTS 


quality of roadbed, on account of the saving in operating expenses 
which this makes possible. Ultimately, extra main-line tracks 
will become an absolute necessity. Even the capacity of one 
double-track line is elastic: it can be increased by improving the 
system of signaling—at some extra expense. Meanwhile, 
operating expenses have been increasing, but in different ways. 
So long as the road merely puts more cars and engines on the line 
and runs more trains, train-crew expenses keep even pace with 
traffic. But when larger engines are bought and the roadbed 
improved so that they can haul heavier trains, then for a time, 
perhaps, this element of operating expense may not increase at 
all, though the cost of loading and switching and car repairs goes 
up. All these stages of growth exhibit, in a sense, different laws 
of cost, requiring separate study. 

In this chapter we shall find it possible to distinguish, statis¬ 
tically, three grades of change: daily and monthly fluctuations 
and the long-run trend of growth. Some of the statistical mate¬ 
rial is in the form of comparisons of different roads for the same 
year, correlating cost with density of traffic. This obviously has 
nothing to do with the shorter fluctuations of business and cost, 
but it has a very considerable bearing on what any road must 
expect to pass through as its traffic grows and its plant and organi¬ 
zation are adapted to meet the increasing demands made upon 
them. These figures are about the best indications available of 
the very long-run trends of growth. 

2 . LONG-RUN TRENDS 

The movement of costs from year to year is warped by changes 
in the purchasing power of the dollar, until the increase due to 
increased traffic is impossible to distinguish with any exactness. 
This is especially true, of course, of the figures since 1913. In 
order to give these data much intelligible meaning, it would be 
necessary to construct a rough index-number of the cost of various 
goods and services entering into railroad construction and opera¬ 
tion, together with figures showing what percentage of the plant 
was constructed at any given date (and hence at any given cost). 
Data are not easily available for an adequate study of this sort. 


RAILROADS AND COSTS 


261 


So far as money expenses go, operating expenses have 
increased more slowly than traffic throughout nearly the entire 
history of American railroads, producing a steady decline in 
operating expense for each unit of traffic. From the time the 
Interstate Commerce Commission began gathering its figures 
until 1896-97, this movement was helped out by a steady fall in 
the general level of prices. From the bottom point of prices until 
about 1910, increased economy in operating expenses was more 
than sufficient to overcome the upward trend of prices, so that 
with decreasing rates the roads showed increasing net earnings. 

The period from 1911 to 1917 represents the turning-point. 
During this period, in spite of rising prices, operating expenses 
kept almost exact pace with traffic, while from 1918 on, the 
upward sweep of wages and prices has dwarfed all other move¬ 
ments so far as operating expenses are concerned. 1 Property 
investment, however, has grown more slowly than traffic, clear 
up to the present time (spring of 1923). 2 Evidently there has 
been a great reduction in the real cost of railroad transportation, 
but it is impossible to say definitely how much represents the 
effect of increased traffic and how much is due to improvement 
in the art of railroading. 

1 These trends are so clear, for the most part, that a casual inspection of the 
Interstate Commerce Commission’s figures suffices to establish them. For the 
period from 19 n on, the writer has constructed a table, comparing operating 
expenses with a composite traffic unit, consisting of revenue ton-miles plus three 
times the actual number of revenue passenger-miles. The results are as follows 
(fiscal years to 1916; calendar years 1916 and thereafter): 


Year 

Operating Expenses 
(Percent of 1911) 

Traffic 

(Per cent of 1911) 

1912. 

103 

103 + 

1913 . 

114+ 

115 + 

I 9 I 4 . 

116 — 

112 

1915 . 

106-f- 

I06 + 

1916. 

ii6-|- 

127 + 

1916. 

124— 

134 + 

1917 . 

149- 

147 + 

1918. 

208+ 

152 + 

I 9 I 9 . 

231 + 

143 + 

1920. 

306+ 

153 - 

1921. 

239 + 

123 + 


3 See Chart I, p. 263. 





















262 


ECONOMICS OF OVERHEAD COSTS 


Certain of the physical statistics afford a little more light. 
Chart I (p. 263) shows the relative growth of trackage, cars, 
locomotives, property investment, and revenue ton-miles, for a 
period of twenty-one years. The number of cars and locomotives 
has far from kept pace with traffic, ever since 1909, but this fact 
does not justify the inferences so often drawn for propagandist 
purposes. It is neither an alarming symptom of under¬ 
equipment nor an evidence of superhuman efficiency in the use of 
a dwindling supply of facilities, for the simple reason that it has 
been almost entirely made up for by the increase in average 
capacity per car and per locomotive. Total freight-car capacity 
has nearly kept pace with traffic; fully so until 1916. And while 
1921 shows a suspicious lag, it is not more than a few years of 
active building would suffice to restore. Judging by the experi¬ 
ence of the years 1917, 1918, and 1920, there has been serious 
under-equipment, and any economies which may come from 
increased traffic will not take the shape of making it possible to 
get along with a smaller supply of car capacity in proportion to 
the amount of business. 

As for locomotives, while their number has far from kept pace 
with traffic, their total tractive effort has, in general, fully held 
its own. Meanwhile the average trainload (revenue ton-miles 
per freight train-mile) has gone up from 396 tons in 1911, to 652 
tons in 1920, subsiding to 578 tons during the depression of 1921. 
And the number of freight train-miles was actually less in 1920 
than in 1911, by a fraction of 1 per cent, though freight traffic 
was 62 per cent heavier. 1 Evidently, during this period at least, 
whatever expenses are governed by the train-mileage might 
fairly be called constant so far as the effect of increased traffic 
was concerned. Increased traffic was being handled almost 
wholly by larger trains rather than by more of them. The 
increased trainloads were about equally due to increased car¬ 
loads and to increased number of cars, carloads increasing materi¬ 
ally faster than did the capacity of the cars. 

1 See Statistics of Railways of Class I, 1911-1921, a statistical summary issued 
by the Bureau of Railway Economics, Washington, 1922. 


CHART I 


RAILROADS AND COSTS 


263 





The percentage relationship of railway traffic and railway facilities on an annual average of 1902 to 1906, 
inclusive, as a base of 100. Reproduced by permission from the Railway Age (January 6, 1923), p. 20. 



































































264 


ECONOMICS OF OVERHEAD COSTS 


One probable effect of this increase in trainloads may be seen 
in the fact that the expense for maintenance of equipment 
grew faster than any other class of expenses during this period, 
increasing from 21.8 per cent of total operating expenses to 27.5 
per cent. Since these major divisions of operating expense com¬ 
monly maintain a fairly stable relation to each other, this large 
disproportionate growth in ten years is very significant. It looks 
as though the growth of trainloads has reached the point of 
increasing cost, not in the work of moving the train, but in the 
wear and tear on the rolling-stock. 1 This is aggravated because 
into these trains are coupled cars of different ages, many of which 
are not built for the strains on draft gear and underframe pro¬ 
duced by the modern large trainloads. The safest place for such 
cars is at the end of the train, but this is not always easy to man¬ 
age, and in any case the impacts of switching are bound to be hard 
on the weakest cars. 

These longer trains require more yard tracks, but the track 
space occupied by the newer and larger cars does not increase 
nearly as fast as their total capacity, so that a considerable saving 
is possible here. Chart I shows that yard tracks and sidings have 
increased a trifle over 70 per cent while total freight-car capacity 
was increasing about 97 per cent. Multiple tracks have almost 
exactly kept pace with freight-car capacity—surely a coincidence, 
but suggesting the empirical generalization that the cost of a 

1 This tendency to increased maintenance costs is shown in the following 
figures, taken from the statistical bulletin of the Bureau of Railway Economics, 
already referred to: 


Year 

Maintenance of 
Equipment. 
Percentage of Total 
Operating Expense 

Revenue Ton-Miles 
per Freight 
Train-Mile 

1911... 

21.8 

39<5 

1912. 

22.3 

421 

1913 . 

23.2 

457 

1914 . 

23.6 

465 

1915 . 

24.6 

488 

1916. . 

251 

550 

1916. 

25.2 

565 

1917 . 

24.1 

603 

1918 .... 

27.7 

634 

1919 . 

27.9 

637 

1920 .. 

27.3 

652 

1921. 

27 -5 

578 























RAILROADS AND COSTS 


265 


single track may be regarded as a constant investment, additional 
line-trackage varying, in the long run, about in proportion to 
traffic, while other investment increases in a materially smaller 
ratio. 

If one were to pick out a single central cause of economy that 
stands out in these figures, it is the fact that larger locomotives 
and cars take up less room on the tracks in proportion to their 
capacity, cost less to construct, and are generally more effective. 
In the case of cars, the larger sizes show a lower proportion of 
“dead weight” to paying load, though the largest cars are plainly 
in sight of the limit of desirable economy in this direction. 1 How¬ 
ever, even where there is no more economy to be had from 
increased size of cars, there are savings which come from merely 
increasing their numbers, because larger repair installations are 
more economical. 

Chart II represents an engineer’s estimate of the investment 
necessary for adequate repair facilities. It shows a slight econ¬ 
omy in the case of cars, and a very large one in the case of loco¬ 
motives. This difference may be explained partly because there 
are so many cars that even a moderate-sized road can secure the 
chief economies of numbers, while locomotives are fewer in num¬ 
ber. The character of the machinery used offers another possible 
explanation. 

3. LORENZ* COMPARISON OF DIFFERENT ROADS 

So much for the attempt to trace the yearly trend of railroad 
expenses. More definite quantitative indications can be arrived 
at in another way. Dr. M. 0 . Lorenz, chief statistician of the 
Interstate Commerce Commission, has published a very inter¬ 
esting analysis, in which he compares the operating expenses per 
gross ton-mile of about eighty of the chief railroads of the coun¬ 
try and correlates them with density of traffic, after making allow¬ 
ance for one large disturbing factor—the varying length of haul. 2 

1 Figures given in the Railway Age (April 28, 1916), p. 936, indicate that a 
70-ton hopper car is about as efficient as a 90-ton car, though either is more efficient 
than cars of 50 to 60 tons. 

* Quarterly Journal of Economics , XXX (1915), 205. 


266 


ECONOMICS OF OVERHEAD COSTS 


CHART II 



ioo 200 300 400 500 600 700 800 Locomotives 

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Cars 

Fig. 1.—Showing desirable relation of repair facilities to equipment owned 1 



100 200 300 400 500 600 700 800 Locomotives 

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Cars 


Fig. 2.—Showing desirable relation of repair facilities to equipment owned, 
translated into aggregates. 


Reproduced by permission from an article by V. Z. Caracristi of New York, 
a consulting engineer, entitled, “What Shop Equipment Means to a Railroad,” 
Railway Age (March 18, 1922), pp. 745, 747. 































































Total operating expense per mile of Operating expense per gross ton¬ 
line ($000. omitted) mile, in mills 


RAILROADS AND COSTS 


267 


The result shows, on the whole, a very consistent trend, as shown 
in the accompanying diagrams (Chart III, Figs. 1 and 2). The 
figures given by Lorenz show operating expenses per gross ton- 
mile, modified so as to be correct for a 200-mile haul. These are 


CHART III 




o 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 

Fig. 2.—Gross ton-miles per mile of line (000,000 omitted) 


shown in Figure 1, together with a curve constructed by the pres¬ 
ent writer on the basis of a constant expense of $1,300 per mile of 
line and a variable expense of 1.7 mills per gross ton-mile. This 
curve appears to fit the figures fairly closely, and in any case the 
downward trend with increased traffic is unmistakable, tapering 






















































268 


ECONOMICS OF OVERHEAD COSTS 


off and almost disappearing as traffic becomes very heavy, pre¬ 
cisely as would be the case with the general type of curve repre¬ 
sented by a constant cost per mile of line plus a uniform variable 
outlay per ton-mile. 

In Figure 2, the same data are presented, but converted into 
the equivalent total expense per mile of line, and the line which is 
drawn through them is the same line, translated into the new 
notation: $1,300 per mile of line plus 1.7 mills per gross ton-mile. 1 
In Figure 2, one thing becomes apparent which was not visible 
in Figure 1: namely, that the trend of the points appears to be 
slightly concave downward. This may be due to other things 
than traffic, especially since the roads of least tonnage include 
most of those which run through mountainous country and have 
heavy grades and other accompanying difficulties to contend with. 
As the points stand, a broken line would fit them somewhat 
better than a straight one. Up to 2,000,000 ton-miles per mile 
of line, the trend is better represented by $800 per mile of line 
plus 2 mills per gross ton-mile, while beyond this point, $1,500 
per mile of line plus 1.65 mills per gross ton-mile would show at 
least as good a fit. This broken line shows one interesting char¬ 
acteristic: namely, that for roads of light or moderate traffic, 
“constant costs” roughly approximate one-fifth of the total, 
while for most of the roads of heavy traffic (more than 6,000,000 
ton-miles per mile of line) constant costs are more nearly one- 
tenth of the total. 2 

1 Incidentally, these two diagrams illustrate clearly the two ways of representing 
the economies of increased business, showing what happens when one is translated 
into the other. When total costs are used, constant expense is, of course, a hori¬ 
zontal line, and variable expense is a line sloping upward to the right. When 
costs per unit of business are used, constant costs take the shape of a hyperbola, 
the equation for which would be xy—K, that is, volume of traffic multiplied by 
cost per unit is a constant. Variable costs, if uniform in amount, now become a 
horizontal line. 

3 It would be possible to draw a curve such that at every point the differential 
cost of added business, multiplied by the total volume, would absorb four-fifths 
of the total expense at that point, leaving exactly one-fifth as “residual” cost. 
(It could not be called “constant,” as it is continually changing.) The curve 
y— 2.762 1/x* would satisfy these conditions, and would fit the points about as 
well as either the straight line or the broken line, up to 5,000,000 ton-miles per 
mile of line. 


RAILROADS AND COSTS 269 

One disturbing element in these figures is due to the fact that 
they include railroads in different sections of the country, some 
predominantly in the prairies, some in the western mountain 
region and some in the east; some carrying chiefly coa] and ore, 
and some moving large amounts of miscellaneous package freight. 
For that reason the writer has tried the experiment of dividing 
the roads into groups, so that each group should contain roads 
roughly comparable in the character of their traffic and the topog¬ 
raphy of the region through which they ran. One result was that 
the groups became too small to furnish good statistical material 
and in some cases covered too narrow a range of variation in 
density of traffic. Each group showed a trend very similar to that 
of the whole, but showing slightly less economy with heavier 
traffic. In other words part of the downward trend of costs per 
ton-mile is due to more favorable topography or larger percen¬ 
tages of cheap low-grade freight, or both. 

For instance, the roads running through the Rocky Moun¬ 
tains show higher costs than any others for similar traffic densi¬ 
ties, and their traffic densities are mostly below the 2,000,000 
mark, so that one might say that the Rocky Mountains are under 
the left end of the curve, raising it higher than it would otherwise 
be. A correction for this factor would increase the variable cost 
of traffic in difficult sections, and reduce the constant costs in 
favorable regions, but the indications are that only a slight cor¬ 
rection would be required. Variable costs of 1.7 to 1.8 mills per 
gross ton-mile and constant costs of $1,200 to $1,300 per mile of 
line would probably cover the range of the different sectional 
trends. Individual roads, of course, vary far more than this. 

Here is a statistical hint of what a road may expect as traffic 
grows and its plant and organization grow with it. It tell^^a very 
different story from the formula which says that half the operating 
expenses are constant, yet it shows the whole outlay varying as 
if a part of it—one-fifth to one-tenth or less—were independent 
of traffic. If the same method of study were extended to cover 
interest on investment, and perhaps taxes, it would be found that 
they also vary with traffic, but not so directly as operating 
expenses. The constant element is larger than for operating 


270 


ECONOMICS OF OVERHEAD COSTS 


expenses, and the variable element smaller. However, under 
present conditions of terminal congestion and high costs of real 
estate fo r terminal uses, it seems probable that the roads have 
reached a point at which investment increases fully as fast as 
traffic, wherever large cities have to be entered. It is not possible 
to secure accurate evidence on investment, as it is in the case of 
operating expenses. The best possible data on this point will be 
furnished by the valuation records secured by the Interstate 
Commerce Commission, when they shall be completely available. 
When that time comes, it is to be hoped that Dr. Lorenz will 
analyze them in the same way in which he has analyzed operating 
expenses, and so complete the picture. 

4. A CASE OF DAILY FLUCTUATIONS 

In the meantime, let us turn for a moment from long-run 
adjustments and examine some data of a very different sort, 
representing the shortest kind of fluctuations. These figures 
show the cost from day to day of handling freight in the Cleve¬ 
land station of the Baltimore & Ohio Railroad, for the four 
months, January to April, inclusive, 1913. 1 Each point shows, 
by its horizontal dimensions, the volume of traffic on a given day, 
and by its elevation it shows the total expense of operating the 
terminal on that day and handling that volume of tonnage. (See 
Chart IV.) 

From this chart several things are clear. Expense plainly 
varies with a great many other things than tonnage. Evidently 
less depends on the number of tons handled than on their char¬ 
acter, and whether they come at convenient times or not, and 
whether the afternoon train is on time or late. If the force 
has to work overtime, expense goes up, and a washout on the line 
is quite as likely to be responsible for overtime as a heavy volume 
of tonnage to load and unload. In fact, costs appear to vary 
almost without regard to traffic, up to about 560 tons, and then 
comes a sudden change. Beyond that point costs not only 

1 The original article and chart from which these data are taken appeared in 
the Railway Age, February 25, 1916. The costs per ton were there given, but the 
present writer has taken the liberty of translating them into totals, because in 
this way the trend of the figures becomes much more evident to the eye. 


RAILROADS AND COSTS 


271 


increase, but increase a great deal more than tonnage. Thus the 
figures show the two chief characteristics of short-time fluctua¬ 
tions, in a rather extreme form—the comparative unresponsive¬ 
ness of costs to traffic, and the congestion point or point of over¬ 
load, beyond which costs are intensely responsive. 

In general production, this increase of costs is commonly due 
to green labor and heavy overtime charges, together with a 
substantial increase in accidents, spoilage of materials, etc. It 

CHART IV 1 


200 


IQO 


l8o 


170 

l6o 

150 

140 

400 SOO OOO 

Cost of handling freight, Cleveland terminal, B.&O. Railway. 

Horizontal scale, tons handled; vertical scale, total operating expense, in dollars. 
0 January, 1913 a > Accident on the line 

+ February, 1913 b, c, Bad weather 

O March, 1913 








0 

( 

> 

— 




/oo 



7 











0 

0 










€ 



0 

0 

D 


0 

ZOO ^QQ coo 






c* 

t* 

.+ 

■f 

0 

O 

1 

© 

-1 

* + 

. 

+° 

• 

* 




♦ 

• • 

m 

♦ 

• 

$ ‘ ‘ 

T 

• * 

K* * ' 
* 

h 

• 

-C 

) 






+ 

~¥~ 









may represent congestion of plant facilities, but it is quite as likely 
to register an overtaxing of the capacity of a labor force which 
cannot be easily and rapidly increased. Not every study of 
day-to-day fluctuations would show such a large percentage of 
costs independent of traffic. This depends largely on the system 
of wage payment. With a piece wage, direct costs, at least, 
would obviously vary almost in proportion to volume of work 

1 Adapted from data published in the Railway Age (February 25, 1916). 
The small inset gives an idea of the range of fluctuations, by carrying the scale 

back to zero. 

































272 


ECONOMICS OF OVERHEAD COSTS 


turned out, except for overtime, while almost every kind of work 
would permit the management to economize when business is 
slack to a greater extent than this railroad terminal seems to have 
been able to do. The expenses of hauling this same tonnage 
would behave differently from the expense of loading and unload¬ 
ing it. For any particular division on any particular day the 
critical point would be whether an increase of traffic made neces¬ 
sary the running of an extra train or not. 

But we cannot spend the time necessary for a thorough study 
of these very short fluctuations. The chief reason for dealing 
with them at all is to show by a concrete example that the “ vari¬ 
able cost” due to these daily ups and downs of production is quite 
a different thing from the variable cost appearing as the result of 
longer swings, so that it would usually require quite a different 
formula to express its behavior in any given case. The effect 
of daily fluctuations on expense appears to depend chiefly on the 
ease with which labor can be laid off or put on part time, and on 
the system of wage payment. These in turn are conditioned by 
the character of the work and the quality of labor required. 
Another important circumstance is the extent to which various 
kinds of postponable work can be utilized as eveners. 

The chief economic importance of a study of such fluctuations 
consists in serving as a guide to reduction of the wastes that result 
therefrom. However, the financial outlays of the company, 
taken by themselves, would be a very imperfect index for this 
purpose, tending either to exaggerate or minimize the real wastes, 
according to circumstances. Where labor is freely laid off or put 
on part time, fluctuations may make little apparent difference in 
the unit expense of producing goods and yet there may be a con¬ 
siderable waste of productive power which the industry has, in 
the long run, to support. This means that they have to pay 
higher wages than they would if employment were more regular. 
On the other hand, if the company pays its men by the day and 
gives them a full day’s pay even where there is not a full day’s 
work for them to do, it is probable that on busy days the force 
does more work than could be gotten out of it for the same wages 
if the same pace were maintained day in and day out. Moderate 


RAILROADS AND COSTS 


273 

changes of pace are rather favorable than otherwise to the effi¬ 
ciency of labor, so long as they are fairly evenly distributed so as 
to avoid cumulative fatigue on the one hand and times of under¬ 
maintenance and financial worry on the other. Within these 
limits, irregularity is not a waste, and the true cost of work, both 
to the laborer and in the long run to the employer, is about the 
same per unit in active and in relatively inactive times. For 
fluctuations within these limits, a day-wage system tends to 
exaggerate the waste resulting from daily ups and downs. 

5. THE SEASONAL CYCLE OF TRAFFIC AND COSTS 

So far we have studied the longest adjustments and the short¬ 
est fluctuations. There is an intermediate type of movement 
which it is possible to study in some detail, thanks to the fulness 
of the statistics published by the Interstate Commerce Commis¬ 
sion: namely, the fluctuations from month to month. One 
obvious difficulty here arises from the disturbance due to changes 
in rates, wages, and prices of materials used. This, however, 
can be minimized, and, in fact, almost eliminated, by studying 
the typical yearly cycle and comparing, for a term of years, the 
average January with the average February, and so on. By 
means of this device it is possible to secure a very interesting 
picture of the seasonal cycle of traffic and costs on American rail¬ 
roads. 

Railroading in the United States is a thoroughly seasonal 
industry. The cycle differs from road to road, and from section 
to section, while there is a different peak for mail and express, for 
passengers, and for different classes of freight. The passenger 
peak comes typically in August, while the dull time (November 
to March) appears to run about 77 per cent of the August peak. 1 
The peak for mail and express is governed by the Christmas holi¬ 
days, while the greatest aggregate fluctuations are in freight, and 
the peak here is governed by the moving of the crops and the 
autumn concentration of coal shipments. The economic pre- 

1 Based on figures for revenue passenger-miles, 1918-21, Railway Age (January 
7, 1922), p. 18. The writer has made allowance for the differing lengths of the 
months. 



274 


ECONOMICS OF OVERHEAD COSTS 


ponderance of freight traffic makes this cycle outweigh all the 
others in its effect upon costs and earnings, the peak coming 
almost invariably in October for the country as a whole, with 
September a very close second, and the lowest point in January, 
with a surprisingly regular climb from January to September and 
October, and a rapid drop from October to January. 1 In general, 
the lowest month is about 80 per cent of the highest, the exact 
percentage varying slightly according to the measure employed. 
The difference between the lowest week and the highest week 
would, of course, be appreciably greater. 

As for the effect of this rhythm upon expenses, this constitutes 
a statistical problem of extreme difficulty; nevertheless the main 
results stand out clearly. Operating expenses vary with volume 
of traffic, and vary just about half as much as traffic does. In 
other words, the figures bear out the generally accepted formula, 
showing that “half the operating expenses are constant and half 
variable,” for these month-to-month fluctuations , hut for no other 
type of movement. Presumably the experts who gave us this 
formula had tacitly in mind fluctuations of about the amplitude 
and duration which these monthly figures measure. This form¬ 
ula is separately corroborated, in whole or in part, by three differ¬ 
ent statistical studies, using different measures of traffic and of 
expense. Thus, while the available units of measurement are 
very unsatisfactory, and disturbing forces are many, nevertheless 
this empirical rule of half-and-half may be regarded as reasonably 
well verified—for month-to-month changes only. 

Before presenting samples of the results of such study in 
graphic form, some warning should be given as to the whys and 
wherefores of the diagrams. In the first place, they take gross 
earnings as a measure of traffic. Ordinarily, changes in rates 
would vitiate this measure, but they have little chance to vitiate 
a comparison of the average January, 1908-17, with the average 
February, 1908-17, and so on. Only seasonal changes could 
seriously disturb such a comparison. There are some seasonal 

1 In this statement allowance is made for the different lengths of the months: 
otherwise February would appear to be the month of lowest traffic. This point 
will be more fully discussed below. 


RAILROADS AND COSTS 


275 


changes of passenger rates, chiefly due to reductions in summer, 
but these are not sufficient to alter appreciably the general trends 
shown. There are also some changes from month to month in 
freight revenue per ton-mile, but these are due more to changes in 
the goods shipped than to changes in rates, and where such 
changes are concerned, ton-miles are no longer an accurate meas¬ 
ure of essential service rendered. For instance, ore is carried 
almost entirely during the six months from May to October, 
inclusive, or, say, between the middle of April and the early part 
of November. This is due partly to dependence on the Great 
Lakes, and partly to the fact that iron ore, for example, freezes 
in winter and cannot be dumped. But ore is low-grade freight, 
moving in huge trainloads and handled very cheaply, and the 
same amount of work will move far more tons of ore than of 
mixed merchandise. As a result, it seems probable that earnings 
are a better measure of service rendered, on the whole, than ton- 
miles, for the purpose in hand, since the low rates on commodities 
handled in bulk are a rough measure of the low cost of rendering 
this service. Otherwise, months when bulk traffic is unusually 
heavy would show a false economy, due, not to the volume of 
traffic, but to its character. 

Furthermore, the figures show a climatic cycle as well as a 
traffic cycle. Transportation costs rise with winter blizzards 
and spring floods. Coal consumption per gross ton-mile may be 
as much as 50 per cent heavier in winter than in summer, 1 and 
train crews spend more time on their runs. Maintenance of 
way and structures on the other hand is lightest in winter, when 
many roads renew no ties at all. Some roads, in fact, divide 
their maintenance-of-way budget into twelve equal parts, and 
charge each month with its quota, regardless of the time when 
renewals are actually made. Thus the figures for maintenance 
of way and structures are worse than useless as indexes of the 
effect of traffic on costs and must either be allocated on some rea¬ 
sonable basis or disregarded entirely. 

With these things in mind, we may look at Chart V,which 
gives some selected results representative of a considerable num- 

1 Based on figures reported for one division of the Baltimore & Ohio Railroad, 
iq 18-20. 


276 


ECONOMICS OF OVERHEAD COSTS 



380 400 420 440 460 480 500 520 


Fig. 1.—Gross income (horizontal scale, $000,000 omitted) and hours worked, 
omitting maintenance of way and structures (vertical scale, 000,000 omitted) for 
large steam roads, U.S., July, 1921—June, 1922 (figures reduced to equivalents for 
30-day periods). 



Fig. 2. —Gross income (horizontal scale) and operating expenses (vertical 
scale) for large steam roads, U.S., average yearly cycle, July, 1907—June, 1917 
(figures reduced to equivalents for 30-day periods and yearly upward trend 
eliminated, $000,000. omitted). 

Solid line, operating expenses, with maintenance of way and structures 
allocated as two-third constant and one-third variable. 

Broken line, operating expenses, omitting maintenance of way and structures. 

Dotted lines show trends as they would be if expenses varied proportionately 
with earnings. 


I 






































RAILROADS AND COSTS 


277 


ber of similar attempts to bring some sort of order out of this con¬ 
fusion. Figure 1 covers a single space of twelve months, and 
measures cost in terms of hours worked, while Figure 2 covers a 
term of years and measures expenses in terms of money. 1 Either 
method eliminates the effect of changing wage-rates. Both show 
clearly the effect of weather as well as the effect of traffic, the 
result being a loop. In Figure 2, the increase from May to Octo¬ 
ber is on a lower scale of costs than the decrease from October to 
January, while February shows the effect of winter at its height, 
and the downward trend from February to May clearly has little 
to do with traffic. The best index of the effect of traffic is prob¬ 
ably the trend from May to October, for here costs are not mate¬ 
rially disturbed by weather conditions. During these months 
costs grow almost exactly half as fast as traffic. 

In Figure 1, the winter increase in coal consumption is not 
included, which may account for the fact that the gap between 
winter and summer is smaller than in Figure 2. The yearly drift 
upward appears also: May and June, 1922, start off on a higher 
level than the trend of July to September, 1921. In fact, if one 
of these studies were prolonged through several cycles, by over¬ 
lapping averages, the result would be a form of spiral, in which 
could be seen both the monthly variation, and also the yearly 
rise, as shown by the trend of successive Januaries, successive 
Februaries, etc. This yearly trend shows costs rising faster than 
traffic while, in the same curve, the May-to-October trend shows 
costs rising half as fast as traffic, thus exhibiting plainly that these 
two movements are independent of each other and follow different 
laws. 

The only other study of this character which has come to the 
writer’s notice was made, apparently, on one road only, and led 
to the conclusion: “For this particular railroad it is to be expected 
that the per cent of increase or decrease in man hours and expense 
will be about one-half the per cent of increase or decrease in 
traffic. The actual results on one railroad were 56 per cent for 

: The source of these data is the bulletins of monthly revenues and expenses, 
and of employees and compensation, issued by the Interstate Commerce Com¬ 
mission. In constructing Figure 1, the writer made use of a tabulation prepared 
by Mr. S. FI. Nerlove, of the School of Commerce and Administration, University 
of Chicago. 


278 


ECONOMICS OF OVERHEAD COSTS 


one year, 58 per cent in the second and 57 in the third.” 1 Further 
than this, the actual results of the study cited are not published; 
only figures which are ‘‘fictitious but indicative of the results 
obtained.” The measure of traffic used was a compound one 
made up of gross ton-miles for freight, and passenger train-miles 
for passengers, but the article did not state what weights were 
given the two figures. In any case, passenger train-miles would 
not naturally be expected to vary as much as passenger-miles, a 
fact which would tend to make the resulting percentages larger 
than if passenger-miles had been used. (This study was made 
for the purpose of setting standards of operating efficiency rather 
than for any purpose connected with traffic policy.) 

To say that half the expenses are independent of monthly 
changes in traffic may be roughly true, but it tells only a small 
part of the story of the seasonal cycle of traffic and costs. The 
main divisions of expense—maintenance of way and structures, 
maintenance of equipment, transportation and traffic—all have 
their special peculiarities. Maintenance of way and structures, 
as already noted, seems to be distributed wholly according to 
weather, yet the wear and tear of traffic causes damage which 
must be made good sooner or later, and this damage is a cost, 
even if the books do not show it. In the upper curve of Figure 2 
(Chart V), this unrecorded variable cost is estimated at one-third 
of the total outlays of this class. 

Maintenance of equipment is also in part a postponable 
expense, so that the expenditures in any month do not record 
accurately the wear and tear taking place during that month. 
Equipment may need repairs and still be able to move, and such 
equipment will be kept on the line when the traffic is heaviest. 
The natural tendency is to distribute repairs over the months 
preceding and following the peaks, so that the heaviest outlays 
might come during the months before and after the heaviest 
traffic. The writer has seen figures for one road indicating just 
this kind of behavior. Both classes of maintenance expense 
include depreciation charges, which go on at a uniform rate, even 
though actual depreciation may be heavier in some months than 

1 Railway Age (July 1, 1922), p. 12. 


RAILROADS AND COSTS 


279 


in others. On the whole, then, it appears that the true variable 
cost is appreciably larger than the figures show. Also, this differ¬ 
ential cost is apparently about 10 per cent larger in midwinter 
than in the months from May to October. And it is quite pos¬ 
sible that any attempt to fill up the midwinter depression in traffic 
would increase differential costs still farther. 

One of the most important features of this cycle is the utiliza¬ 
tion of the labor force, and here one of the chief questions is 
whether the changes are taken care of by changing the number 
of hours worked or by laying men off and taking them on. With 
regard to this, the figures show that, except for maintenance of 
way and structures, the number of workers employed remains 
remarkably steady. Fluctuations are taken up chiefly by work¬ 
ing more or less hours, and these changes are not large enough to 
be serious, except as they may be concentrated on special groups 
of laborers. 1 In maintenance of equipment there is, however, 
a change of perhaps 14 per cent in the number of employees, while 
in maintenance of way and structures only about two-thirds as 
many are employed in midwinter as in summer. Evidently the 
chief burden of casual labor falls upon this last group of workers, 
and it is not to be remedied by stabilizing traffic, since traffic has 
virtually nothing to do with the distribution of their work. 

The effect of this seasonal cycle on net earnings is most strik¬ 
ing. The autumn peak typically shows twice the net earnings 
of the winter depression. 2 The autumn months thus appear by 
far the most profitable, though really the reverse is more nearly 
true, since this autumn traffic is responsible for the size of the 
investment and for a large part of the maintenance charges on 
this investment, charges which fall on the other months as part of 
their burden of “constant costs.” Additional business “on the 
peak” would cost the roads vastly more than additional business 
in the off months, even in winter when costs per unit are increased 

1 These statements are based on Mr. Nerlove’s tabulation (already referred 
to, p. 277 above, footnote) of the Interstate Commerce Commission’s monthly 
bulletins of employees and compensation. 

2 Based on figures published by the Interstate Commerce Commission for 
1912-16, inclusive. In subsequent bad years, net earnings have reached the 
vanishing-point during the off season. 


280 


ECONOMICS OF OVERHEAD COSTS 


by bad weather conditions. To whatever extent it may be prac¬ 
ticable to reduce the seasonal swings of traffic, the result will be a 
saving in interest and maintenance, and an increase in efficiency 
that would be worth very considerable effort and sacrifice. 

Can these gains be secured ? The question is not a simple 
one, partly because the same shift of traffic that would mean a 
better load-factor for one road might mean a worse one for some 
of its connections. The simplest economic weapon is a system of 
seasonal rates, offering concessions to off-peak business and put¬ 
ting relatively heavier burdens on business which aggravates the 
peak. Taken by itself, this would ordinarily not have much 
effect except to reduce the roads’ revenues, because it would be 
easier to get authorization to reduce the off-peak rates than to 
increase rates on the peak, while the rail rate alone would not, in 
most cases, offer sufficient inducement to ship goods at a less con¬ 
venient season. The thing requires patient planning and the 
co-operation of miners, manufacturers and merchants: in short, 
of all the interests concerned in the efficient handling of the 
business in question. The railroads’ reduction of rates would 
then be only one of a series of concessions by different interests 
and in various forms, all made in recognition of the economy of 
utilizing idle overhead. 

Not every irregularity would be possible or desirable to elimi¬ 
nate. The crops will probably always move seasonally, though 
storage near the farm may in some cases make shipments more 
regular. Traffic in coal can undoubtedly be made more regular 
if miners, railroads, dealers, and large users act together. Ore 
offers no prospects of furnishing anything but seasonal traffic; 
and so on. Each commodity presents its peculiar problems, but 
here and there will be found opportunities for improvement. 
The chief thing needed is a vivid realization that additional off- 
peak business is profitable at anything above its differential cost 
—say 40 per cent of average rates—and that added business 
“on the peak” is a loss unless it yields considerably more than 
the present average rate. 


CHAPTER XIV 


OVERHEAD COSTS AND RAILROAD 
RATE PROBLEMS 

SUMMARY 

The lowest remunerative rate, 281—Traffic in busy and in dull seasons, 282— 
The segregation of railroad expenses, 287—Terminal costs, 288—Haulage costs and 
distance, 289—Adaptability of a “cost” system of rates, 290—Some principles 
bearing on discrimination, 293— Making money by lowering rates, 295 —Con¬ 
clusion, 297. 

I. THE LOWEST REMUNERATIVE RATE 

Railroad rate-making in this country has grown up on 
the practice of “charging what the traffic will bear.” The 
theory of overhead costs has been used chiefly to justify this 
practice and to give it the benefit of the doubt, and only 
secondarily to attempt to set quantitative limits on it. Where 
such limits have been thought of, the minimum has been con¬ 
ceived as “variable cost,” using the formula which states that 
half the operating expenses are variable and nothing else; or 
else an attempt has been made to trace the direct operating 
expenses attributable to the traffic in question, and set this 
as a minimum. This question of the minimum below which dis¬ 
crimination should not go has gained increased practical and 
legal importance since the Interstate Commerce Commission 
laid down the rule that relief from the long-and-short-haul clause 
should be granted only on condition (among other things) that 
the lower rates were in themselves remunerative. Under this 
rule, how much discrimination is justified ? 

To set the minimum at half the operating expenses is clearly 
wrong, in the light of the foregoing study, since this is applicable 
only to seasonal rates made to stimulate off-peak business— 
a type of discrimination which is virtually nonexistent and 
has nothing to do with the long-and-short-haul clause. To 
disregard investment costs and indirect operating expenses 
is equally wrong, in the typical case, for the typical case involves 


281 



282 


ECONOMICS OF OVERHEAD COSTS • 


a general rate policy, which, if it is consistently followed, will call 
forth considerable volumes of traffic, which will in turn involve an 
increase both in indirect operating expenses and in investment. 
What should be reckoned is the long-run differential cost of 
growth of traffic, taking for granted that it will grow for an 
indefinite time and in very considerable amounts, and that the 
railroad which has brought this traffic into being cannot after¬ 
ward refuse to handle it, nor hamstring it by raising rates to an 
extent which would cripple the shippers. 

Judging by the evidence analyzed in the previous chapter 
(especially Chart III) the amount of discrimination which -would 
be possible without making the lowest rates absolutely unremu- 
nerative would depend upon the density of traffic on the road in 
question. The minimum remunerative rate would not vary 
markedly between roads of dense and roads of sparse traffic, since 
differential cost does not appear either to rise or fall materially as 
traffic increases; but average cost varies greatly, and hence the 
relation of the minimum to the average would vary. Allowing 
roughly for the variable element in interest and taxes, it would 
be fair to conclude that the lowest remunerative rate would be 
v not much less than three-quarters of the average rate for the 
country as a whole. For roads of very dense traffic, whose 
rates are below the average, this would leave very little room for 
discrimination on the principle of “charging what the traffic 
will bear.” For roads of sparser traffic and higher average costs, 
it would be reasonable to charge a higher average rate, if they 
could get it, so that in their case the range between the minimum 
rate and the average would be considerably greater. For 
roads of sparse traffic, then, the lowest remunerative rate might 
be as low as half the average cost, including interest and taxes. 
This would, of course, leave a very wide margin between the 
highest and the lowest rates, in case such roads attempted 
to “charge what the traffic would bear” in the literal sense of 
exacting the utmost from traffic which would stand high rates. 

2. TRAFFIC IN BUSY AND IN DULL SEASONS 

So far we have been going on the assumption that the 
traffic is average traffic. If its special characteristics make 


COSTS AND RAILROAD RATE PROBLEMS 


283 


it more expensive than the average, or less expensive, this differ¬ 
ence should, of course, be taken account of. The characteristics 
of traffic, which affect its cost, are almost too numerous to attempt 
to mention. One, however, is worth mentioning because it is so 
generally overlooked in discussions of the subject: namely, the 
seasonal character of the traffic. Does it come chiefly in the 
busy season, is it evenly distributed or--best of all—does it 
concentrate in the partly idle season when it can be carried by the 
regular force and the regular equipment which the “peak” 
traffic makes necessary in any case P 1 

There is every probability that traffic which falls heavily 
on the September-October peak does not pay its fair share of 
the “capacity costs,” including interest and taxes as well as 
those operating expenses which do not vary with seasonal ups 
and downs of traffic. The crucial point is the locating of respon¬ 
sibility for these capacity expenses, and in this there is large 
latitude for judgment, but an example may serve to make plainer 
the nature of the case on which judgment has to be exercised. 
This example will deal with freight haulage costs alone, taking 
for granted for the moment that expenses have been separated 
as between passengers and freight, and as between terminal and 
haulage outlays for both classes of traffic. 

Let us suppose a freight traffic of 2,000,000,000 gross 
ton-miles per year with total haulage costs of $6,000,000 or 
3 mills per gross ton-mile, including $4,400,000 for operating 
expenses and $1,600,000 for interest and taxes on the invest¬ 
ment assigned to freight haulage. Operating expenses then 
come to 2.2 mills per gross ton-mile, and interest and taxes 
to .8 mills. Of these expenses only half of 2.2 mills, or 
1.1 mills, are variable with seasonal changes of traffic, but 
in the long run the differential cost of added business will come 

* Theoretically, there are two peaks to consider, the peak for the road as a 
whole and the peak for the special kind of rolling-stock which this traffic requires. 
In the case of freight, however, the curves of demand for box cars, open-top cars, 
flat cars, stock cars and even refrigerator cars, are enough alike so that one might 
fairly ignore their differences for most purposes. (See diagrams of car shortages 
and surpluses covering 1919-21, Railway Age, January 7, 1922, p. 17.) Passenger 
train equipment, however, is a different story, and has its own distinct peak. 


284 


ECONOMICS OF OVERHEAD COSTS 


to about 2.25 mills (three-quarters of 3 mills), assuming that 
this is a road of fairly dense traffic. This 2.25 mills includes 
the equivalent of the 1.1 mills of short-run variable costs and a 
residuum of 1.15 mills per gross ton-mile which, for lack of a 
better name, may be called “capacity costs.” They vary in the 
long run, but not from month to month, and are governed more by 
the capacity of the road than by its momentary output. 

These capacity costs should be fully borne by the traffic 
which makes them necessary and all traffic should bear its share, 
but what is the share of a given class of traffic ? If the seasonal 
peak on this road is of the usual magnitude, it will amount to 
about 185,000,000 gross ton-miles for the heaviest month, but 
since September and October are so nearly equal, it is fair to 
think of the peak as lasting two months. Now, strictly speaking, 
these two months are chargeable with the entire “capacity cost” 
for the year. A 5 per cent increase in the peak traffic necessitates 
a 5 per cent increase in capacity, and nearly that much in capacity 
costs, while an increase or decrease in the off-peak traffic wdll 
have no effect on them whatever. The total capacity costs come 
to $2,300,000, and distributed over a two-months peak they 
would come to 6.22 mills per gross ton-mile of traffic during the 
two heaviest months. Thus the lowest remunerative charge 
(to cover haulage costs only) for September or October traffic 
would be 6.22 mills plus 1.1 mills or 7.32 mills per gross ton-mile— 
more than twice the average cost for the whole year. Terminal 
costs would presumably behave in similar fashion, with the 
result that the road not only could not afford to cut rates to 
increase its peak traffic, but would lose money on that traffic 
unless it yields considerably more than twice the aver¬ 
age rate! If this basis of calculation is correct, most roads are 
losing money on their heaviest month’s business. 

This is on the assumption that the “capacity costs” are 
governed entirely by the demand of these heaviest months, 
and not at all by the traffic offered the rest of the year. This, 
however, is probably not strictly true. If the off-season traffic 
were very small, the roads would not provide as good quality 
of roadbed and equipment for the peak traffic as they now do. 


COSTS AND RAILROAD RATE PROBLEMS 285 

J 

These capacity costs represent, not merely a surplus of cars 
which he absolutely idle in the dull season, but improved roadbed 
and better facilities, which mean lower operating costs throughout 
the year. Even the surplus of cars is in part a relative matter: 
it makes it easier to furnish a shipper promptly with just the 
type and size of car he calls for and so is not wholly useless. Thus 
the peak does not stand absolutely alone as sole cause of the 
capacity costs, and it is not really correct to charge the entire 
capacity cost to the two peak months. When we ask how much 
of it to charge to the peak and how much to distribute over 
the other months, the question ceases to be a mere matter 
of arithmetic and becomes a matter of judgment. 

Let us say that half the capacity costs, or at the very 
least a third, are fairly chargeable against September and 
October and the rest agaaist the other months of the year. 
On the half-and-half basis, the cost of the September-October 
traffic would be 4.11 mills per gross ton-mile, while the off¬ 
season traffic would cost 1.734 mills. If only one-third of 
the capacity costs were charged to the peak months, the peak 
traffic would cost 3.22 mills and the off-peak traffic 1.95 mills. 
Thus, on the most favorable possible assumption, the long-run 
differential cost of traffic coming during the peak months is 
more than the average unit cost of all traffic, including a pro 
rata share of interest and taxes. This corroborates the inference 
that, at average rates, the roads actually lose money on 
their months of heaviest traffic instead of making their largest 
profits out of those months, as they appear to do on the face of 
the accounts. 

Should this fact find expression in the rates? Common 
sense says that it should be taken account of in some way or 
other. Should rates in general be made higher in September 
and October than in the other months so that the traffic during 
these months should earn its fair share of the costs of unused 
capacity which go on during the rest of the year ? The 
answer to this question is not simple nor clear. Certainly 
such a step should be taken only after thorough study of 
the burdens it would impose on industry and the extent to 


286 


ECONOMICS OF OVERHEAD COSTS 


which it would be possible for industry to escape these burdens 
by shipping at other times, without increasing its own costs 
more than it would reduce those of the railroads. For this 
is not merely a railroad problem: it is a part of the larger prob¬ 
lem of the seasonal character of industry in general, and it 
will not be solved until industry as a whole takes effec¬ 
tive steps to estimate the costs of seasonal irregularities and 
to reduce them wherever possible. Seasonal rates on rail¬ 
roads may be justified wherever they show promise of producing 
actual results as a part of some such comprehensive policy. 
Taken by themselves and imposed indiscriminately, they would 
probably do more harm than good. 

A compromise measure would be to make no seasonal changes 
in rates, but to distinguish between those commodities which tend 
to aggravate the seasonal cycle and those which tend to improve 
it, charging the latter higher rates the year round, so that each 
class of traffic will pay for any idle overhead it may occasion. 
This appears legitimate enough, but it does not do anything defi¬ 
nite to make any given shipper ship at more convenient times. 
Thus it neglects the chief point which must underlie a scientific 
rate system. 

While the seasonal peak in passenger traffic is quite as well 
marked as in freight, the economic questions which it raises are 
even more involved. The peak comes in the months of vacation 
travel, when freight traffic has not reached its peak; therefore, 
so far as passengers and freight use facilities in common, the 
heavy passenger traffic is off-peak business. There are also 
shorter peaks at other seasons—notably the Christmas holidays— 
to complicate the situation. And there is a large “overload 
capacity” in passenger facilities, since travelers will endure over¬ 
crowding at rush times which would rouse an insistent demand 
for more accommodations if it became chronic. Hence it is hard 
to locate the responsibility for the capacity expenses. Clearly 
the peaks of travel are not the sole governing factor, and prob¬ 
ably not the main one. Thus it is virtually impossible to set up 
any particular system of passenger rates as embodying the one 
scientifically correct seasonal distribution of overhead expenses. 


COSTS AND RAILROAD RATE PROBLEMS 


287 


3. THE SEGREGATION OF RAILROAD EXPENSES 

What about the separation of expenses between passengers 
and freight and between terminal and haulage ? This is a con¬ 
troversial point, and the merits of the argument depend largely 
upon what use is to be made of the allocation. If the entire 
expense is divided into two parts, passenger and freight, and if 
it is then insisted that passenger and freight traffic must each 
earn the entire expense charged to it, no more and no less, then 
it becomes pertinent to object that many facilities and services 
are used in common and that bases for allocating these common 
items are necessarily arbitrary and full of shortcomings, so that 
any division based on them has little claim to scientific exactness. 

These objections, however, would lose most of their force if 
the division of expenses were to be used in a more moderate way, 
insisting merely that each main division of traffic should at least 
earn the sum of the long-run differential costs for which it is 
responsible. This would be little less than the whole cost for 
roads of dense traffic, leaving them little room for “charging 
what the traffic will bear.” But the sum of the differential 
costs would be far short of the whole, giving wide latitude for 
discrimination, in the case of the poorer roads with sparser traffic, 
which naturally have the hardest time to cover their overhead 
costs and need the most freedom of rate policy. If the separation 
of expenses were to be used in this way, the management might 
decide that passenger traffic could not afford to bear any of the 
residual costs and these might be thrown on the freight traffic; 
similarly it might be decided that the terminal portion of the 
rate should not be burdened with these costs, and they might 
fall entirely on the haulage portion. Such a policy might seem 
extreme, but would be within the range of discretion which the 
proposed rule would allow the management. 

Under these conditions, the separation of costs appears less 
doctrinaire and inexorable. In its support four propositions may 
be laid down. (1) All expenses vary, in the long run, with utiliza¬ 
tion. (2) The variable component can be roughly calculated. 
(3) Indexes of utilization are imperfect, but an imperfect index is 
better than none. (4) The use of such indexes to allocate costs. 


288 


ECONOMICS OF OVERHEAD COSTS 


and the requirement that each class of traffic shall cover at least 
the long-run variable component of the costs allocated to it, 
would tend to prevent parts of the traffic from being a burden 
on the rest, but would not unduly limit the discretion of the 
management. 

4. TERMINAL COSTS 

The separation of terminal and haulage costs might be used 
to make a rough allowance for length of haul, charging each 
shipment for two terminal handlings, regardless of distance, 
plus a haulage charge of so much per ton per mile. Such a 
system, however, would unduly simplify both the terminal and 
the haulage costs and services. Cost of haulage is different for 
solid through trains and for mixed local trains, and some services 
of a terminal character have to be repeated at transfer points, 
where carloads of mixed shipments for different destinations 
are unloaded and reloaded into straight carloads for single 
destinations, or where trains of cars for different destinations are 
sorted into solid trainloads for single destinations. 

In view of the number and variety of terminal services, it is 
not certain whether it would simplify or complicate rate-making 
to make separate charges for all the principal ones. Certainly 
there is room for simplifying the present practice, which makes 
special charges in some cases (switching charges, etc.,) and none 
in others, and “absorbs” some of the customary charges. If 
the most important terminal services could be covered by a 
charge representing the long-run variable cost of the service, 
then “charging what the traffic will bear” would be confined to 
the haulage charge and the net result might be a desirable 
simplification of rate-making. The importance of the terminal 
element in expense is indicated by an estimate attributed to 
Commissioner Wooley, of the Interstate Commerce Commission, 
that one-third of all railway operating costs are terminal costs; 
while the varied character of these costs is indicated by a survey 
made of the terminals of Boston, showing that different move¬ 
ments require from five to nine single car moves, and cost from 
$6 to $12 per car. This includes an allowance for taxes and 6 
per cent on investment, and these items make up 49 per cent of 


COSTS AND RAILROAD RATE PROBLEMS 


289 


the total cost. The whole estimate is thought to lean toward 
liberality, but from it one may roughly estimate that two such 
movements cost as much as 100 miles of hauling. 1 

5. HAULAGE COSTS AND DISTANCE 

The effect of distance on haulage costs is apparently one of 
the simpler elements in rate-making, yet the more one examines it, 
the less simple does it become. In a general way, cost undoubt¬ 
edly increases with distance, yet in special cases it is not easy 
to trace the effect. It may be cheaper in some cases to haul a 
solid train to a junction point and then take a short haul back to 
an intermediate point, rather than carry the freight all the way to 
the intermediate point by the more expensive local train. How¬ 
ever, this would only be true if the terminal movements at the 
junction were simple and the yards free from congestion. 

Or we may take the case of a milk train which travels the 
length of a division, starting empty and arriving at the city with 
a full load. The cost of this train is governed chiefly by the 
maximum cargo it has to carry, and the first shipment it picks 
up costs little more than the last, though it may travel ten times 
as far. Thus, within the limits of the length of the division and 
of the capacity of one train, cost may be independent of distance. 
However, if there is so much traffic as to call for a number 
of trains, and some of them can make shorter runs if their cargo 
comes from nearer points, then distance begins to govern cost 
in a material way. Thus the system of making milk rates by 
zones of considerable width, disregarding distance within the 
limits of each zone, seems to correspond fairly to the facts of 
cost for this type of traffic. 

Suburban passenger traffic is governed by somewhat similar 
conditions, except that here there are usually so many trains 
required that any material increase in the average distance 
traveled would increase the total volume of train movement 
and so increase costs. This suburban traffic is dense and regular, 
and hence cheap to handle, while its commutation tickets econo- 

1 Estimates reported by John C. Owers, Railway Age (August 19, ig 22 )» PP- 
337-39. They were criticized by the Interstate Commerce Commission in its 
decision in the Boston Wool Trade Association case, decided June 6 , 1922. 


290 


ECONOMICS OF OVERHEAD COSTS 


mize the labor of ticket agents, but it uses very expensive term¬ 
inals, and there is a very real question whether it is not carried 
at a loss in view of the very low rates it enjoys and the heavy 
investment involved. A sample study of haulage costs and of 
terminal costs for large cities, small cities, suburban points, and 
country towns might yield very instructive and useful results. 

6. ADAPTABILITY OF A “COST” SYSTEM OF RATES 

If a system of rates were to be built on the principle of cost, 
would it be so rigid as to hamper reasonable allowances for com¬ 
mercial conditions ? Not necessarily. In the first place, the 
principle of cost requires only that every class of business cover 
its own long-run variable costs, leaving a margin to be collected 
on the principle of “what the traffic will bear.” This margin 
would be small for roads of dense traffic running through sections 
where production is well established, and does not need to be as 
tenderly nursed by rate concessions as in poorer regions. Where 
traffic is sparse and industry and commerce less firmly estab¬ 
lished, there would be sufficient margin for all reasonable con¬ 
cessions which might need to be made. 

The rate system is naturally confined to certain objective 
facts or criteria on which rates and rate-differences are based. 
The first is covered by the classification. Different commodities 
may receive different rates, or the same commodity may receive 
different treatment according to the way in which it is packed 
and shipped. Here it is possible to take account of the special 
costs of loading and unloading, special care required in handling, 
risk of damage, and percentage of car-capacity which the traffic 
utilizes. This last could be fairly well taken account of by a 
uniform haulage charge of so much per gross ton-mile, since 

traffic which uses only a small part of the capacity of the cars 

* 

or which forces the road to haul cars back empty, would be 
charged accordingly, and each ton-mile of paying freight would 
have a large gross ton-mileage charged against it for hauling the 
empty car. 

Secondly, there is the size of the shipment. Differentiation 
on this ground is severely limited in the United Stares, under 


291 


COSTS AND RAILROAD RATE PROBLEMS 

j 

a long-established ruling of the Interstate Commerce Commis¬ 
sion, recognizing the difference between carload and less-than- 
carload shipments, but no other. Yet in regions where certain 
products are staple, they move in large volume and are cheaper 
to handle for that reason, and as the forces of sectional competi¬ 
tion center in these products, at least in the regions where they 
originate, the roads are impelled to give this fact recognition. 
This takes effect in the regional classifications, where the products 
in which each region feels a special interest receive lower ratings 
relatively than they do in the classifications of other regions. 
The most important ones receive still more elastic treatment 
through special commodity rates. This is one reason for opposi¬ 
tion to a nation-wide uniform classification, and such a classifica¬ 
tion would, to some extent, discriminate sectionally against the 
products which move in heavy volume in each section, except 
as they were taken care of by means of commodity rates. While 
regional classifications may be inconvenient and undesirable 
they do not seem necessarily to violate the principle of cost. 

The third objective fact on which rates hinge is the origin 
and destination of the shipment, and the distance covered. 
Here it is possible to make rates according to distance, either 
on a uniform mileage basis, or on a tapering scale, or by zones 
of different widths. Such scales might be used in various ways, 
as minima or maxima, or both. At present, more and more of the 
local rates are being fixed on such scales, while competitive points 
get lower rates than the local scales would entitle them to. 

It is interesting that the system of express rates installed 
by the Interstate Commerce Commission in 1913 was based 
fairly closely (as analysis of the figures will show) upon a fixed 
charge for the shipment, a charge varying with weight, and a 
charge varying with the product of weight and distance. 1 
Another interesting fact is that the system of charging what the 
traffic will bear commonly results in a tapering trend which 
might be called natural. Chart VI shows such a natural tapering 
trend in the rates on coal to towns in seven southern states. 

1 See also A. S. Field, in the American Economic Review , III (December, 1913) 
831-62, esp. p. 834. 


292 


ECONOMICS OF OVERHEAD COSTS 


An examination of this curve makes it seem probable that 
the longest hauls, and perhaps also the shortest, pay relatively 
little above the long-run differential cost of carriage, while the 
residual costs are distributed fairly evenly over the intermediate 
distances. In short, it appears to be the sort of curve that 
might be worked out by constructing a minimum scale based on 

CHART VI 



Trend of carload rates on coal from natural sources to all towns of 5,000 or 
over in Alabama, Georgia, Kentucky, Tennessee, North Carolina, South Caro¬ 
lina, and Mississippi. Hauls grouped according to distance and each group 
averaged. Data from statement of J. D. A. Morrow before Interstate Commerce 
Commission, January 19, 1922, Appendix, Part C. Published by National Coal 
Association, Washington, D.C. 


long-run differential costs, and distributing a share of residual 
costs between the different distances according to what those 
distances would reasonably bear, and then smoothing the curve to 
avoid sharp breaks. 

It is impossible here to go into all the conditions affecting 
cost of service. These would include special types of cars, 


Dollars per ton 













































































































































































































































































COSTS AND RAILROAD RATE PROBLEMS 


293 


special loading equipment, expensive bridges and other struc¬ 
tures, differences in topography, etc. All these would justify 
wide variations in charges. Nor is it possible to discuss all the 
problems and principles of rate-making, nor the many ramifica¬ 
tions of the policy of “ charging what the traffic will bear.” A 
few points, however, may be touched upon. 

7. SOME PRINCIPLES BEARING ON DISCRIMINATION 

In general, the relation of cost to rate-making may be summed 
up as follows: Rates should cover long-run differential cost. 
For roads of dense traffic this is so near total cost that one might 
as well say that rates should be based on cost, as near as can be 
estimated without making the cost studies unduly burdensome. 
For roads of sparser traffic and higher costs, the same scale used 
by their more favored competitors might serve as a workable 
minimum, with leave to go below it in case of need, to develop 
traffic. Where two shippers or two hauls compete with each 
other in a direct way—as, for example, the competition of eastern 
and western flourmills, which centers in the rates on flour and on 
wheat—differences in rates should be governed by differences 
in costs, even where absolute costs cannot be discovered. 

In fact, the principles involved here are the same which 
have long figured in arguments between free-traders, urging a 
“natural” distribution of industry, and protectionists, urging 
a cultivated distribution. The key of the “natural law” argu¬ 
ment is the doctrine of comparative costs, which requires the 
charge for transport to correspond with the cost of doing the 
work. Admitting the general argument, exceptions are urged for 
“infant industries” which require only temporary favors; to 
avoid destruction of “vested interests” (such as the manufactur¬ 
ing interests of New England, now working under a transportation 
handicap); to make sure of “key” industries which will bring 
others with them (if a railroad secures the building of a factory 
on its line it can count on large amounts of incidental and derived 
traffic); and to promote a socially and politically desirable 
distribution of industry. On these points the arguments over 
railroad rates and customs tariff parallel each other closely and 


294 


ECONOMICS OF OVERHEAD COSTS 


departures from the rule of comparative cost are theoretically 
justified on these grounds, in both cases. 

However, it is one thing to make special rates to develop traffic 
and another thing when the only result is to divert traffic from 
one line to another. Where rates are cut below the normal 
relation to cost, merely to secure existing traffic for this or that 
rival line, the efficiency of the transportation system as a whole 
is not increased by utilizing unused capacities, but more often 
diminished by routing traffic over roundabout lines when more 
direct ones exist. 1 Is there any justification for such tactics ? Is 
the Interstate Commerce Commission right in sometimes allowing 
roundabout lines to take traffic from more direct ones without 
lowering their own intermediate rates to the level of the com¬ 
petitive through rates ? 

The question is not easy, but the principles we have been 
discussing offer some help toward its solution, suggesting an 
important angle of the problem which is not often clearly recog¬ 
nized. The roundabout route, which for that very reason usually 
has the sparser traffic, is in a difficult position, often the result 
of no fault of its builders. It is rather the victim of manifest 
destiny. After the most necessary roads have been built, others 
are needed, and are needed to tap other territory which is 
naturally not so rich as that occupied by the first roads. They 
are justified because of developing this new territory, but they 
cannot make a living from its local business alone without 
charging exorbitant rates. They are also useful in times of 
great business activity to serve as overflow routes for through 
traffic which it would ordinarily be cheaper to haul by the more 
direct route. They represent capacity available for the peak 
load, but partly idle most of the time. 

This “ readiness to serve” is of great value to the country’s 
industry, but how can they collect an adequate reward for it? 
Certainly not by waiting till the congestion of the other lines 
forces traffic their way. This would give them a square meal 

x This question is discussed by Ripley, Railroads: Rates and Regulation , 
chap, viii; and by H. G. Brown, Transportation Rates and Their Regulation , chaps, 
iv and vi; and by others. 


COSTS AND RAILROAD RATE PROBLEMS 


295 


once every two or three years, and leave them to tighten their 
belts between times. No; if they are socially justified, they have 
a right to a steadier income than this. A subsidy ? Perhaps, if 
one could be agreed upon! Failing that, their handicap can at 
least be mitigated by letting them carry, in ordinary times, 
whatever share they can of the competitive through traffic. 

This is wasteful, perhaps, viewing ordinary times by them¬ 
selves, but they do not stand by themselves, and the burden 
involved is probably the cheapest form of subsidy. This 
argument would perhaps not fit all conditions, but it is of fairly 
general application. Regional consolidations would be a better 
solution of the difficulty, but failing that, the weaker lines may 
well be allowed a dispensation to meet the rates of their stronger 
rivals and secure a reasonable share of the competitive traffic. 

This principle, however, would need to be very carefully 
applied in practice. Where two roads poach upon each other, 
each one stealing some of the other’s natural traffic, no useful 
end is served, and the result is unmitigated waste. For this and 
other reasons, the direct lines should be held to a system of rates 
that does not violate the principle of cost. Then if a roundabout 
line meets these rates, it does not give the junction any advantage 
it did not already possess by virtue of distance. Being nearer 
the other end of the line than are intermediate points on the 
roundabout line, it gets a lower rate, and the intermediate points 
lose no advantage of geographical position, even if through 
traffic is hauled past their doors at a lower rate than they have to 
pay. 

8. MAKING MONEY BY LOWERING RATES 

One other question has lately been given a very significant 
emphasis. At the time of the agitation for the “Plumb Plan” 
for semi-public administration of the railroads, the advocates 
of the plan claimed that the roads could lower rates and that 
the reduction could be made self-sustaining because it would 
increase traffic, and the economies of increased traffic would make 
the roads better off with lower rates than they had previously 
been with higher. It was freely prophesied that, in a reasonable 
time, rates could be reduced 40 per cent by this method. The 


296 


ECONOMICS OF OVERHEAD COSTS 


foregoing studies of cost should furnish sufficient answer to such 
claims. If traffic doubled in ten years or five, and rates were 
reduced 40 per cent, gross income would only increase 20 per 
cent, clearly not enough to pay for the added traffic. If traffic 
were trebled in fifteen years and rates reduced 40 per cent, total 
revenues would increase only 80 per cent. The increase in 
revenue would be 4 per cent for every 10 per cent increase in 
traffic. But, as we have seen, the long-run differential cost of this 
traffic would be far more than four-tenths of average cost: it 
would be more nearly twice that amount, and the reductions 
could not possibly be made self-sustaining. 

One case could be cited in support of this plan for reducing 
rates. During the depression of 1921 the Interstate Commerce 
Commission, with the virtual acquiescence of the carriers, 
ordered a reduction of rates in the hope of stimulating a revival, 
or at least to avoid stifling it by maintaining rates which business 
could not pay and prosper. The experiment appears to have 
been justified by the outcome: traffic and earnings have revived, 
and an observer might infer that the reduction was good for the 
treasuries of the roads. 

But it is one thing to help regain ground lost during a depres¬ 
sion, and to start the cumulative forces of revival on their way; 
and it is quite another thing to attempt to develop such an 
increase of business as the Plumb Plan argument called for. In 
the case of a depression hanging on the edge of revival, small 
v causes may produce large results rather quickly; in the other 
case large causes might produce very slow and disappointing 
results. Moreover, in 1921 the roads had large amounts of 
unused capacity, so that the added cost of added business was 
at a minimum, and the economy of increased traffic at a maxi¬ 
mum. Variable costs may have been about 40 per cent of average 
costs, or even less. But with such a sustained growth of traffic 
as the Plumb Plan contemplated, more capital would be required, 
and the added costs of added traffic would go up by leaps and 
bounds, reaching three-quarters of average costs at the very 
least. This would preclude any possibility that large reductions 
of rates could pay for themselves by the economies resulting 


COSTS AND RAILROAD RATE PROBLEMS 297 

j 

from the increased traffic they brought forth. This claim can 
only be plausible so long as no serious attempt is made at quanti¬ 
tative reckoning of the added costs due to added traffic. 

9. CONCLUSION 

We have here considered only a few aspects of the relation 
of costs to railroad rates. However, a comprehensive treatise 
on railroad rates is not part of the task of this book, and we must 
pass on to a brief consideration of the transportation system as 
an organic whole, including railroads, streets and highways, 
and waterways. 


CHAPTER XV 

THE TRANSPORTATION SYSTEM AS A WHOLE 

SUMMARY 

The size of the transport industry, 298—Economic problems Involved, 302— 
Some questions of highway economy, 304—Highways versus railways, 307— 
Benefits of improved highways, 309—Inland waterways and overhead costs, 311— 
Conclusion, 316. 

I. THE SIZE OF THE TRANSPORT INDUSTRY 

The people of the United States probably spend not less than 
one-quarter of their annual economic income on transportation. 
And presumably not less than one-quarter of the country’s 
productive energy takes effect in moving people and commodities 
from place to place, though much of this energy is not directly 
engaged in the work of haulage. It includes a large share of 
the mining of coal, the refining of gasoline, the making and 
repairing of vehicles, and other forms of manufacturing tributary 
to the transport industry. Under most circumstances these 
would be classed as extractive industry and manufacturing, but 
for the present purpose the essential point is that their results 
are utilized via transportation, and their effectiveness in actual 
service is made or marred by the effectiveness with which the 
results of all this outlay are put together in the work of moving 
the American people and its goods. This transport bill, huge 
beyond the power of the mind to grasp the meaning of figures, 
is one of the incidental penalties of our industrial greatness, 
resulting from free intercourse over continental areas and great 
concentrations of production, with all the efficiency which these 
things bring with them. 

The avenues of transport may be broadly classified into 
streets, country roads and paved rural highways, steam railroads 
and street and interurban electric roads, improved rivers, 
canals, the Great Lakes, and the ocean with its arms and harbors, 
while the air may have to be reckoned with in the near future. 


298 



TRANSPORTATION S fSTE^M AS A \^OLE 


299 

The total investment of capital involved in transport has been 
estimated at $50,000,000,000, including approximately $20,000,- 
000,000 for railways and nearly as much for highway transport, 
$5,000,000,000 for electric railways and a little less for inland 
waterways and marine transport. 1 The estimate for highway 
transport omits city streets and all unimproved roads, but the 
same authority puts paved city streets at $4,000,000,000. 
While the magnitude of highway transport is significant, more 
significant still is its recent and enormous growth, for it has 
multiplied between five and sixfold in a decade and is still grow¬ 
ing rapidly, while railroads have remained relatively static 
during the same period. Clearly we have to adjust ourselves 
to a revolution in transportation. A modern motor highway 
may cost $20,000 per mile or more—equal to the cost of the 
early canals and comparable with costs of way for single-track 
railroads. As a result highways have outgrown former methods 
of financing. 

In 1921 there were in this country about 9,000,000 passenger 
cars and nearly 1,000,000 trucks, 2 the average wholesale value 
new being something over $75o. 3 Allowing for retail values 
less depreciation, $7,000,000,000 would not be an extravagant 
estimate of the investment involved, since the average age 
of the cars is far less than half their normal life, on account of 
the rapid increase in production. These vehicles move on 
improved roads which have been estimated to represent an 
investment of more than $4,500,000,000, paved streets repre¬ 
senting some $4,000,000,000 more, and unimproved roads 

1 See estimate by J. Rowland Bibbins, United States Chamber of Commerce, 
Department of Transportation and Communication, Our 50 Billion Dollar Industry. 

2 The most careful and enlightening statistical study of the automobile industry 
which has come to the writer’s notice is a pamphlet by Leonard P. Ayres, of the 
Cleveland Trust Co., entitled The Automobile Industry and Its Future , 1921 (The 
Cleveland Trust Co.). The total registration of cars and trucks in 1921 was 
10,448,632, but something like 500,000 should be deducted for cars going out of 
use during the year, as Mr. Ayres’s study indicates, though his study does not 
include the 1921 figures. 

3 Facts and Figures of the Automobile Industry , issued by the National Automobile 
Chamber of Commerce, 1922, shows the average wholesale value of the 1921 
output to have been $756, being $723 for passenger cars and $1,080 for trucks. 


300 


i 


, OP .VERHEAD COSTS 


representing an uncertain but very substantial investment. 1 
Garages, etc. (the equivalent of railroad shops, roundhouses, 
etc.) represent a further investment running into billions. Thus 
it seems fair to conclude that the investment in roads, streets, 
and stationary equipment far exceeds that in vehicles. 

It will, perhaps, be worth while to make up parallel budgets 
of investment and expense for rail and motor transport, even 
though the figures for motor transport necessarily contain too 
much guesswork to be entitled to scientific standing. Suffice 

TABLE II 

Comparative Budgets of Rail and Highway Transport 



Railroads, U.S. 

Class 1, 1920 

Streets and Highways 

Maintenance of way and structures, 
including depreciation. 

$1,032,540,381 

4,494,450,891 

5,827,591,146 

750,000,000* 

375,000,000* 

272,061,453 

7,224,652,599 

$900,000,000 

6,000,000,ooof 

6,900,000,000 
500,000,OOO 
420,000,000 
257,ooo,oooJ 
8,077,000,000 

Maintenance of equipment, including 
depreciation, and conducting transpor¬ 
tation . 

Total operating expenses. 

Interest on way and structures. 

Interest on equipment. 

Taxes. 

Total economic sacrifice. 



* This interest is roughly estimated. A large part of it was not earned in 1920. This year shows 
railroad costs at their greatest. They have since shrunk, while highway traffic and costs have gone on 
expanding. 

t 9,000,000 passenger cars at $500 per car, and 990,000 trucks at about $1,500 per truck would 
produce this figure, which thus appears quite conservative, especially as one operator has asserted 
positively that the total expenses of trucks alone were at least $3,500,000,000. 

t These taxes go toward maintenance, but the non-industrial functions of government have a 
fair claim to this much support, and if these are deprived of it, the deprivation is a sacrifice. 

to say that the total economic outlay for motor transport 
clearly exceeds that for railroads, and is divided in very similar 
proportions among the main items of maintenance and interest 
on way and structures, and maintenance and operation of the 
moving equipment. The chief difference is that ‘‘maintenance 
of equipment” for motor vehicles is high, while the cost of “con¬ 
ducting transportation” may be correspondingly low. The 
main heading of “Maintenance,” in the railroad accounts, 
includes depreciation, and depreciation on motor vehicles is 
heavy, since their average life is less than six years. 3 Depreci- 

' Estimates of Mr. J. R. Bibbins of the United States Chamber of Commerce, 
Department of Transportation and Communication. 

* See pamphlet by Leonard P. Ayres already referred to. 


















TRANSPORTATION SYSTEM AS A WHOLE 


301 


ation on roads furnishes a problem, for roads appear to wear out 
in ten or fifteen years; but since about half the investment in 
a highway is permanent and not subject to depreciation, the 
burden need not be more than 3 per cent to 4 per cent, where 
roads are properly built in the light of present engineering 
knowledge. As for interest, railroad capital should yield 6 
per cent, while highway bonds pay considerably lower rates, but 
apart from this difference the interest burdens would not be very 
different, since the investment in both fixed and moving equip¬ 
ment appears to be strikingly similar in amount. 

The costs of the railroads are taken at their highest point, 
while the figures for highways are intended as conservative 
estimates. Of the two, highway costs are expanding far the 
faster. 

If the costs of these two great branches of transportation 
correspond so closely, how do the services rendered compare? 
It is estimated that motor trucks carried, in 1921, 1,430,000,000 
tons as against 1,642,251,000 tons for the railroads, the average 
haul being about 4! miles and the ton-mileage about 6,500,000,000 
as against over 300,000,000,000 for the railways. 1 As the 
capacity of the average freight car is probably more than twenty 
times that of the average motor truck, and there were more than 
two and one-half times as many freight cars as motor trucks, 
it appears that the motor truck accomplishes about the same 
ton-mileage per ton of capacity as the freight car. 

Passenger traffic by motor car can only be guessed at. One 
estimate places the number of passengers carried at nearly 
7,000,000,000, against 1,000,000,000 for the railways, and the 
passenger-mileage at over 70,000,000,000, against 37,000,000,000 
for the steam roads. 2 Electric railroads carried 13,000,000,000 
cash and 3,000,000,000 transfer passengers. Apparently motor 
cars do not produce as large a physical volume of service as 
railways, but on the other hand it is reasonable to reckon the 

1 Facts and Figures of the Automobile Industry (p. 7) quotes these figures on 
authority of the United States Bureau of Public Roads. 

2 This estimate is made by the National Automobile Chamber of Commerce 
in the pamphlet, Facts and Figures, already referred to. 


302 


ECONOMICS OF OVERHEAD COSTS 


value of the service per ton-mile or per passenger-mile at a higher 
figure than the service rendered by rail carriers, so that there is 
no reason for supposing that our highway traffic as a whole is 
not worth what it costs the country. 

As for inland water traffic, it is of very different kinds. The 
Great Lakes carry a huge tonnage of coal, ore, and grain, offering 
probably the cheapest carriage in the world, and the overhead 
cost of harbor and channel improvements, including the Sault 
Ste. Marie Canal, are small in proportion to the total benefit. 
The lakes, moreover, are open for traffic during the September- 
October peak, and thus afford relief from what would otherwise 
be intolerable congestion in the great east-and-west rail routes 
which parallel them. 1 Inland rivers and canals, however, carry 
a small aggregate of traffic, and the overhead cost of channels 
and other works constitutes, in proportion, a very heavy burden— 
one that would be prohibitive in most cases if it were laid as a 
charge on the traffic. The Monongahela River is a notable excep¬ 
tion, carrying large volumes of coal direct from river mines to the 
waterside plants of the Pittsburgh steel district in fleets of barges 
mainly owned and operated by the large steel and coal companies. 

2. ECONOMIC PROBLEMS INVOLVED 

The economic questions arising out of this vast and imper¬ 
fectly co-ordinated system of transportation are many and vari¬ 
ous, and some of the most difficult ones center in economizing 
overhead costs and raising them in a fair and satisfactory manner. 
We have two systems at work. In one the way is publicly 
built and maintained and its use is free to all, so that traffic need 
bear only the costs of “ conducting transportation” and the 
overhead burdens of the vehicle and its accessories, unless special 
taxes, tolls, or fees are charged beyond the usual taxes on produc¬ 
tive captial. Here the decision to build the highway, and what 
kind of a way to build, is made through political machinery 
and subject to political forms of influence, without, in most 
cases, a really adequate economic survey of costs and benefits. 

1 In the case of railways which serve as feeders to the boat lines, lake traffic 
probably does not make the seasonal peak either much better or much worse. 


TRANSPORTATION SYSTEM AS A WHOLE 


303 


Moreover, once the way is built there is, or has been so far, 
very little control over the use or abuse that may be made of it 
by the traffic. 

In the other system, way and traffic are both in the hands of 
the same company. The way is built for just the traffic which 
the company intends to move over it and the traffic is adjusted 
to the way. A railroad will not buy the heaviest locomotives 
if its rails and roadbed will not bear them without undue damage, 
but an overloaded truck will go wherever it is allowed, and the 
damage it may inflict is a matter for the trucks which follow 
and for the public which maintains the roads. And rail traffic 
pays not only the expenses of carriage but maintenance, depreci¬ 
ation, and interest on the way, together with taxes to support 
the general work of government. 

It is clear that under the first system there is more chance 
for waste, and for transportation which is really parasitic. So 
far as the two systems co-operate with each other—and this is 
their chief relation—this problem of waste creates no further 
difficulties. But where the two systems compete, there is a 
question of fairness as well as a possible added waste from divert¬ 
ing traffic to the more expensive route. 

Added to this is the fact that modern motor traffic has 
required revolutionary changes in road construction, and 
engineers are still learning what are the best foundations and 
surfacings, what loads different types of road will stand and 
what kinds of wear or impact cause failures, how long roads 
should last and under what, traffic conditions, and how much 
a worn-out road is worth for purposes of rebuilding. The 
relative value to the traffic of different types of road is another 
thing requiring careful study. Not every road can be of the 
best quality, for the country could not pay the cost. Last, 
but not least, there are questions of financing. How much can 
be raised, and what should be done if it is not possible to raise 
as much money as should, in the interests of efficiency, be spent ? 
Should special assessments, general taxes, or bonds be used or 
should special taxes on the transport industry be used to pay 
the interest on the bonds and amortize the principal? What 


304 


ECONOMICS OF OVERHEAD COSTS 


should be the term of the bonds and the provisions for retire¬ 
ment? How should the burden be divided between towns and 
cities, counties, states, and the federal government ? 

All these troubles, and more, arise from the fundamental 
fact that the way is built by the public and thrown open freely 
to private use—generally to unlimited use. Most of these 
issues would disappear if the same body which built the road 
also operated the vehicles and collected the revenues from them. 
Yet no one would seriously propose to operate highways on this 
plan: the right to use them freely is one of the last refuges of 
personal liberty. Hence these difficulties must be faced and 
somehow answered. 

3. SOME QUESTIONS OP HIGHWAY ECONOMY 

Let us look in more detail at some of the problems of highways. 
Here the paradox of overhead costs assumes an extreme form. 
Before a road is built, it is rational to say that the traffic which 
benefits should bear the overhead cost and that if it cannot bear 
it, the outlay is probably not justified. 1 But once a well-paved 
road is built, reasonable use costs nothing at all, and any charge 
which limits the amount of such traffic would result in unused 
capacity and the loss described by the phrase, “idle overhead.” 
Yet certain kinds of traffic do break down the roads, and should 
pay accordingly or be prohibited. The most effective avenue of 
prohibition is via the manufacturers of vehicles, yet to set a fixed 
limit on the weight of trucks would be clumsy and inappropriate, 
for in congested cities and places where traffic is dense, it is eco¬ 
nomical to build a way that will stand the pounding of the heavy 
truck, while in country districts the cost would be prohibitive. 
Thus the logic of the situation points toward two policies: The first 
is to lay the overhead costs of streets and highways so that they 
will fall on the users, but not solely or chiefly as a direct cost of use. 
Rather it should still take the form of an overhead charge, such 
as an annual license fee. A moderate tax on gasoline might 

1 This statement clearly needs qualification, since it is well recognized that 
no system of tolls could collect all the benefits of such an improvement. The 
thing which economists have called “consumers’ rent” may justify construction. 


TRANSPORTATION SYSTEM AS A WHOLE 


305 


also be justified, especially as there are still some highway 
costs which vary with the general volume of travel, but if the 
tax were made heavy enough to raise a large part of the highway 
overhead, it would check traffic whose “ variable cost” to the 
public would be far less than the tax. Moreover, it would not 
distinguish between a heavy truck and a number of light 
passenger cars, according to their proper shares of the highway 
overhead cost. 

The second indicated policy is to control the weight of 
vehicles so that heavy hauling can be done where traffic justifies 
building heavy roads, while at the same time less expensive 
roads can be used where traffic does not justify the heaviest 
construction, without being destroyed by weights too great 
for them. This offers an administrative problem of some 
difficulty, but the thing can be done if it is regarded as sufficiently 
important. That is, sufficient control can be established to 
protect the highways, though it would never be possible to catch 
every case of overloading. 

Different types of road are damaged differently by use. With 
asphalt the surface ripples; with concrete, the slab cracks under 
impacts. This cracking appears to be due to the one maximum 
impact rather than to the cumulative effect of a series of lighter 
blows. 1 This maximum impact depends on a number of factors, 
including the tires (pneumatic tires produce far less shock than 
solid rubber, and naturally do not lose their cushioning virtue 
with age in the same way) and also the distribution of weight on 
the wheels (most trucks concentrate too much weight on the rear 
wheels for the good of the roads). 

To the extent that concrete becomes the accepted form of 
improved motor highway, it would seem that highway costs 
are governed in large part by the weight of the heaviest loads. 
Some main routes require extra widths on account of the number 
of vehicles, and here the whole width must, of course, be made 
strong enough for the heaviest loads carried, even though a 
narrower road would accommodate all the heavy vehicles. 

1 See Public Roads, November 1921, pp. 4-5. Published by United States 
Department of Agriculture, Bureau of Public Roads. 


3°6 


ECONOMICS OF OVERHEAD COSTS 


Responsibility here is joint. However, where traffic is as dense 
as this there is little question but that the benefits are worth 
the overhead outlay required, unless the cost is exaggerated 
by letting the roads be pounded to pieces. 

The heavy truckload means a saving in overhead costs to 
the operator, but may impose a far heavier burden on the com¬ 
munity. Mr. Mackall, chairman and chief engineer of the 
Maryland State Roads Commission, has described the war-time 
experience of the Baltimore-Washington highway in these terms. 1 

In 1917-18, that road carried a tremendous traffic, not so great in number 
of units as in size of units. For practically its entire length in April, 1918, 
it was impassable. It could not be used for anything except very light 
trucks. The cost of rebuilding that road in 1918 was $600,000. A traffic 
count was taken for the twelve months preceding reconstruction. It was 
not accurate but was approximate. A comprehensive study was made of 
that traffic count and it was demonstrated by the Bureau of Public Roads, 
in a statement which they published, that if all the units of 5 tons or larger 
had been carried on units of 3 tons, taking the manufacturers’ rated effi¬ 
ciency, the cost to the operators would have been $15,000. The people of 
the state of Maryland paid $600,000 to permit a few truck operators to 
save $15,000. 

Whether these figures justify the exact conclusion drawn 
or not, the principle is valid. Apparently it would be cheaper, 
as well as more merciful to the trucking business, to enforce 
limitations on the size and loading of trucks, rather than to 
attempt to collect fees equivalent to the burdens which the 
heaviest loads impose. One mitigating feature is that when a 
concrete road is rebuilt, the old concrete remains as foundation 
and the result is a thicker, stronger road than before, at far less 
than the original cost of construction. 2 In the past, it has been 
estimated, motor highways wear out in from ten to fifteen years, 
but their life should be greatly lengthened in the very near 

1 Conference on Economics of Highway Transport , published by Highway and 
Highway Transport Education Committee, Washington, D.C., 1922, p. 19. Would 
the result have been as striking had the count been made earlier? 

3 Charles Whiting Baker estimates that the old structure may be worth as 
much as three-eighths of its original cost as foundation for a renewed surface. 
See Engineering Neivs-Record, July 10, 1919, p. 55. Grading, of course, is virtually 
permanent. 


TRANSPORTATION SYSTEM AS A WHOLE 


307 


future, partly by control of traffic, partly by better construction 
and partly by the strengthening and consolidation that comes 
with repeated rebuildings. It is an engineering possibility to 
make highways which should be virtually everlasting—at a price. 

As for methods of financing: special assessments on land 
receiving special benefits, license fees on vehicles, and gasoline 
taxes, all have their uses. For some special routes, the old- 
fashioned toll-gate has its virtues, where there is no ordinary 
community intercourse to be interfered with and no very vital 
community interest in promoting traffic. Bonds are an appro¬ 
priate device for synchronizing cost and benefits, if their term 
is no longer than the life of the road. However, the bonds should 
not be a charge on the general revenues of the state, which are 
badly needed to meet other growing needs. Even the special 
assessment has its injustices when it covers the entire cost of 
improvements which benefit motorists exclusively. The non¬ 
motorist landowner has a just grievance. Special assessments 
and vehicle and gasoline taxes should rather divide the burden 
between them both in city and in country. 

4. HIGHWAYS VERSUS RAILWAYS 

Where these two systems of carriage come into competition, 
the one which has to pay its own overhead costs out of charges 
on the traffic naturally feels that the competition is unequal 
and unfair, though no objection was raised to the principle 
of free highways so long as they served merely to feed traffic 
to the railways, not to haul it in competition with them. The 
shortness of the average haul by motor truck (4^ miles) is proof 
that the great bulk of motor haulage is still strictly local and 
does not compete with the railroads. The volume of competitive 
traffic is relatively small, though actually large. The chief 
sense of rivalry is probably felt over motor freight lines hauling 
goods over distances from 25 to 80 or 100 miles, and passenger 
lines operating over shorter average distances. 

The natural field of the motor truck lies in what would be 
less-than-carload business if it moved by rail, requiring a truck 
haul at each end of the trip and four handlings or more. The 


303 


ECONOMICS OF OVERHEAD COSTS 


truck can substitute one long haul with two handlings for three 
short hauls with four or more handlings, and furnish far greater 
speed and reliability into the bargain. On the other hand, the 
operating cost of the truck is high—probably not far from 20 cents 
to 25 cents per ton-mile for the type of truck engaging in this 
business, 1 as against what is probably considerably less than 1 cent 
for comparable railroad expenses. Thus it appears that the 
truck has a decisive advantage on the short hauls, and the rail¬ 
road on long hauls. An increase in the charges on trucks would 
shorten the distance at which the truck could compete, but could 
not eliminate it, without eliminating at the same time most of the 
non-competitive haulage. If the highway overhead properly 
chargeable against trucks is kept within bounds by not allowing 
the trucks to inflict undue damage upon the roads, the remaining 
problem will not assume very serious proportions. 

Fair charges for interest and maintenance of highways may 
be roughly estimated at less than one-fourth of the total vehicle 
costs (including interest, maintenance, and depreciation on the 
vehicles), and the vehicles are already bearing a part of this 
(though not a major part) in the shape of taxes, license fees, etc. 
The trend of development seems to be toward a reduction of 
needless highway overhead and an increase in the burdens falling 
on the motor-user, chiefly for other reasons than the unfairness 
of subsidized competition with railways. Furthermore, the 
railroads may possibly feel this competition more intensely than 
its long-run effect on the earnings would justify (especially 
with rates regulated toward a 6 per cent return), for they are 
naturally inclined to take the standpoint of a road which, for 

1 Cf. Charles Whiting Baker, in Engineering News-Record, July 10, 1919. 
On a pre-war basis, he estimated costs of hauling farm produce over country roads 
at 25 cents per ton-mile, and motor-truck costs at from 12 cents to 25 cents. One 
estimate gives 58.4 cents per truck-mile for a 5-ton truck running 50 miles per day 
for 300 days in the year. This seems a high performance. Another estimate 
gives $23.15 per truck-day plus 14 cents per truck-mile, or about 24 cents per ton- 
mile, if there is an empty haul one way. Mr. Pride, a motor-truck operator, has 
estimated the total expense of motor trucks at $3,500,000,000 per year, which 
would mean over 50 cents per ton-mile. Much of this is in light loads, however. 
See Conference on Economics of Highway Transport at the University of Maryland, 
July 27, 1921, p. 29. 


TRANSPORTATION SYSTEM AS A WHOLE 


309 


the moment, has unused capacity rather than that of a road 
which would, in the long run, have to add to its capital invest¬ 
ment in order to handle the traffic now going by motor. 

If there is a social interest in the case, not represented by the 
bare facts of cost, it probably lies in the fact that highways 
have a value as an emergency system of carriage in case railroads 
are paralyzed by strikes or other difficulties. They can reduce 
what would otherwise be an absolute danger to the life and health 
of the people to the proportions of a serious loss and inconven¬ 
ience. It is probably not a healthy thing for the community 
to be so exclusively dependent upon steel rails, locomotives, 
and the negotiations between railroad managers and railroad 
brotherhoods. The highway, by its very lack of co-ordination, 
is difficult to paralyze—a valuable compensation for the serious 
wastes which this lack of co-ordination involves. There is an 
element of truth back of the popular feeling that the railway has 
the people at its mercy, while the more individualistic means of 
transport are their servants. 

5. BENEFITS OF IMPROVED HIGHWAYS 

The real question is of the quality of roads, rather than their 
quantity, and the more urgent needs for improved roads can be 
gauged by the character and volume of traffic which makes its 
way against the difficulties of the roads in their unimproved 
state. The benefits of good roads should be at least equal to 
their total cost. These benefits may be figured at the actual 
saving in costs of haulage on the previous traffic plus part of this 
same difference on the new traffic brought into being by the new 
roads. One survey estimates that improved roads in eight coun¬ 
ties have reduced hauling costs from 33.5 cents per ton-mile to 
15.7 cents per ton-mile on the average, a saving of 17.9 cents. 1 
This saving was multiplied by the total traffic as indicated by a 
traffic survey after the improvement of the roads, and from this 
total was subtracted the interest and amortization charges on 
the highway bonds. In seven out of eight counties covered 
by this study, the result showed benefits in excess of costs. 

1 United States Department of Agriculture, Bulletin No. 392, October, 
iqi 6, p. 8. 



3 io 


ECONOMICS OF OVERHEAD COSTS 


This estimate is subject to three criticisms. The saving 
per ton-mile is exaggerated in the case of traffic developed by the 
new roads. Since this traffic would not stand the former cost 
of haulage, the total benefit would be the difference between the 
present cost of haulage and the largest cost the traffic in question 
would stand. This would reduce the saving on this new traffic 
by probably about half. In the second place, nothing is charged 
for maintenance, though the new roads require substantial main¬ 
tenance and the old ones received hardly any. Thirdly, in place 
of the amortization charges on the bonds the true charge should 
be the depreciation of the road itself. A forty-year bond with 
a sinking fund may show a very low amortization charge, but if 
the road wears out in ten years, the saving is purely imaginary. 
Allowing for all these factors it becomes more doubtful if the 
average county shows more benefits than costs or more costs than 
benefits, in direct savings on goods hauled. 

However, there are intangible benefits. 1 

Before the roads were improved the average school attendance was 66 
pupils out of each ioo enrolled, as compared with 76 after the roads were 

improved.Not only have the roads contributed toward a larger 

school attendance, but they have been quite instrumental in lifting the 
standard of instruction by making easier the consolidation of little one-room 
schools into graded schools. In Dinwiddie County the system of taking 
the children to and from schools by means of wagons has been adopted since 
the roads were improved. 

Then there is the promotion of community intercourse, and 
other possible intangible values, which justify giving good roads 
the benefit of the doubt. 

Another way of measuring the benefits is by the increase of 
land values. This is quite unreliable, however, since it is im¬ 
possible to distinguish the increase due to roads from that due 
to other causes. The tendency is to credit good roads with the 
entire benefit resulting from the progress of the community. 

There is one important qualification on the principle that the 
service rendered by roads should equal their total cost. It has 
become a commonplace that one of the most promising remedies 

1 From the bulletin cited above. 



TRANSPORTATION SYSTEM AS A WHOLE 311 

> 

for unemployment is to use public works, such as roads, as 
reservoirs of employment and push them more rapidly when the 
volume of employment elsewhere is low. And it has been sug¬ 
gested in an earlier chapter that the differential cost of such 
work to the community is very little, if the only alternative is 
idleness. Accordingly it might be sound to charge part of the 
cost of roads to prevention of unemployment, if they are 
actually used in this way, and if there is not enough work which 
can be so used and whose direct benefits are worth its full 
financial cost. 

However, under ordinary conditions it should be possible to 
find all the work necessary in improvements which are fully 
worth their cost, especially as, in proportion as the policy succeeds, 
it will tend to reduce the strain put upon it. Providing work 
for 100,000 workers would naturally tend to diminish unemploy¬ 
ment by considerably more than that amount. Unless it is 
absolutely impossible, all work should meet the test of creating 
a product worth its total cost. But if this cannot be done, then 
work which could not meet this test might still be worth its 
differential cost to the community, and deficits might rationally 
be charged against prevention of unemployment as a species 
of collective overhead cost of industry as a whole. Road-building 
which is actually used in this way would, on these conditions, be 
economically justified. Or, put it the other way around, if we 
are going to build roads which cannot show traceable benefits 
equal to their cost, they can be furnished with an adequate reason 
for existence by utilizing them as eveners of the curve of 
unemployment. 

6. INLAND WATERWAYS AND OVERHEAD COSTS 

The proper place of inland waterways in our transportation 
system is a subject of much dispute, in which a correct reckoning 
of overhead costs is essential to any logical decision. All that 
can be done here is to point out the general principles involved, 
and some of the difficulties in the case. The waterway is like 
the highway in that, after an improved channel has once been 
built, any tolls charged for its use would prevent some traffic 


312 


ECONOMICS OF OVERHEAD COSTS 


from moving, while the variable cost of the traffic would be 
practically nothing. Since there is such great difficulty in 
stimulating tonnage to move by water in any case, it becomes 
practically out of the question to charge tolls on canals or 
improved rivers. Thus the waterway is relegated to that some¬ 
what hazy borderland where economic justifiability rests on 
demonstrating that benefits exceed costs, even though it is 
impracticable to make them prove it by paying cash. 

Here there are many chances for error. Both cost of construc¬ 
tion and volume of traffic are harder to prophesy than in the 
case of roads, where existing traffic and similar roads offer fairly 
good evidence. With an overestimate of traffic goes an under¬ 
estimate of the burden of overhead costs per ton-mile, and also 
of the added burden of the larger and deeper channels which 
have been so much urged of late years as a cure for the ineffective 
state of inland waterways. There is also a tendency to over¬ 
estimate the capacity of a waterway, calculating both capacity 
and costs on a basis of steady operation at full theoretical capacity 
for both waterway and boats and barges. This exaggerates 
the performance of the boat and thus minimizes the burden of 
its overhead costs—if, indeed, they are taken account of at all. 
Costs of water haulage and terminal handling are often esti¬ 
mated on the basis of operating expense alone, which, of 
course, fails to include the necessary return on the carrier’s 
investment. 

These errors are serious: some of them may make a difference 
of several hundred per cent, and they have a way of combining 
with each other by multiplication rather than addition, so that 
the result is sometimes startling. For instance, if actual cost 
of constructing a canal exceeds the estimate by 50 per cent, and 
the traffic is only 25 per cent of the estimates, then the channel 
overhead per ton-mile is six times the estimates. Then if the 
performance of a towboat and fleet of barges is estimated on the 
basis of too few barges, there is an underestimate of floating over¬ 
head, and if the performance per towboat is estimated on the 
basis of a theoretical capacity which is three times what is 
actually achieved, then the floating expense per ton-mile of 


TRANSPORTATION SYSTEM AS A WHOLE 


313 


traffic will probably turn out some three times the estimate. 
And if the season’s expense per towboat is 50 per cent more than 
the estimate, the cost of traffic will be, not three times the 
estimate, but four and one-half times. 

In estimating the capacity of a canal or canalized river, the 
locks are the limiting factor, and the crucial thing to remember 
is the fact of variability. The number of vessels wishing to 
pass a given lock will not be distributed uniformly throughout 
the day nor through the season, nor will they all use the full 
capacity of the locks. If the traffic per day averages two-thirds 
the rate of the busiest hour, and the traffic per season averages 
two-thirds the rate of the busiest day, and the average craft 
uses two-thirds the capacity of the lock, then the canal will 
begin to be congested when the traffic is at eight twenty-sevenths 
of its theoretical capacity, estimated on the basis of uniform 
operation. Traffic can be pushed beyond this, but only at the 
cost of delays which will result in an insistent call for more 
capacity. In these respects local conditions differ. On the 
Monongahela River tows are very uniform in size, and the stand¬ 
ard tow uses the full capacity of the locks, but on the New York 
Barge Canal this has been far from the case. Most of the barges 
are still the same which plied the old canal, their capacity being 
240 tons, though vessels of 1,500-ton capacity can and do navi¬ 
gate the new channel. 1 Even where tows are made up which 
utilize the full length and width of the locks, the available 
depth is not fully exploited. This condition may prove to be 
temporary, though numerous shippers of moderate size will 
probably always find the smaller craft more economical than the 
larger. 

As for depth of channel, the author once analyzed estimates 
of the cost of construction and operation of a 9-foot and a 12-foot 
channel and found that, accepting these estimates as correct, 
in order that the saving from the deeper channel should pay the 
extra overhead cost involved in its construction, the traffic must 
not merely utilize nearly the full capacity of the canal, but must 

‘See Report , New York Superintendent 0} Public Works on Canals , 1921, pp., 
14-16. 


314 


ECONOMICS OF OVERHEAD COSTS 


utilize it uniformly with boats which require the extra draft. 1 
This is a condition which practically no waterway could meet. 
Indeed, one handicap under which the modern waterway labors 
is that, in order to utilize the capacity of a channel of 9 to 12 feet, 
tows of several thousand tons’ capacity must be employed, and 
few shippers can fill these with regularity, except the large steel 
and coal companies. Smaller concerns have to choose between 
smaller craft, or “idle overhead” in boats and terminals, or the 
use of someone else’s vessels, which generally means an extra 
haul to the loading-point, and an extra handling. 

This matter of terminal costs is probably the chief reason why 
inland water traffic has developed in disappointingly small 
volume. Most manufacturers can secure a spur-track connection 
with a railway and ship carload lots, but relatively few can reach 
a waterway without a haul by truck. Furthermore, a 40-ton 
car is one thing and an 8oo-ton barge another, while a tow-load 
of 1,500 to 5,000 tons is equal to an entire freight train, and 
most plants cannot furnish such quantities. Thus the natural 
candidates for water traffic are the smallest and the largest 
shippers—the less-than-carload shipper, who must stand a truck 
haul in any case, and the shipper of trainloads. Those in between 
have a natural affinity for the carload shipment by rail. On 
many of our inland rivers, terminal costs are increased by the 
need of providing for a rise and fall of 50 feet, or even more at 
times, in the level of the water. This matter of terminal costs 
is one of the reasons why the friends of waterways are continually 
disappointed in the volume of traffic developed. 

In this brief sketch the writer has for the most part avoided 
citing concrete cases 2 and has striven merely to show the impor¬ 
tance of overhead costs and some ways in which they can easily 
be underestimated. In concluding, it may be of interest to pre¬ 
sent in parallel columns an estimate of total cost for a railway 
and a waterway, each to be built new, at pre-war prices, each 

1 The estimates in question were utilized by the Lake Erie and Ohio River 
Canal Board, with reference to the Beaver-Ashtabula project. 

3 H. G. Moulton’s Waterways vs. Railways furnishes a mine of illustrative 
material on this subject. 


TRANSPORTATION SYSTEM AS A WHOLE 


315 


to be 250 miles long and to haul 20,000,000 tons of freight. The 
costs in cents per ton are estimated as follows: 1 



Waterway 

Railway 

Maintenance of way (including depreciation). . 

II. OO 

7 - 5 ° 

13-44 

1.69 

3 - 9 ° 

27.50 

4 69 

8.60 

I 4-85 

20.00 

2.00 

6.4I 

6.76 

4-35 

Maintenance of equipment (including depreciation)........ 

Transportation . .. 

Traffic and general.... ..... 

Taxes, insurance and damages. 

Interest on way........ 

Interest on equipment.... 

Total...... 

69.72 

62.97 


The decisive items in the comparison are interest and main¬ 
tenance of way, since these together constitute the overhead 
cost borne by the public. These two items come to over 55 per 
cent of the total waterway cost, and would be more if the tonnage 
developed proved smaller than the estimate. Eliminating these 
two items from both columns, the waterway would cost only 
31.22 cents, against 47.62 cents for the railway, or about two- 
thirds the cost by rail. 

To take a specific case, the items of interest, depreciation, 
maintenance, and operation on the New York Barge Canal 
amount to a sum which is probably about $12,000,000, or more 
than $8.00 per ton of freight moved in 1921. 2 This counts the 
investment in the new canal only, and credits the new canal 
with all the traffic it now carries, though its tonnage is not yet 
equal to that carried by the old canal at the time it was closed for 
the building of the new one. 3 This places a heavy burden of 
proof on those who hope that the canal may show benefits equal 
to its cost. The difference between rail and water rates on 
grains apparently amounts to the equivalent of about 40 cents 
per ton, while on class freight the difference may average over 

1 Based on a table in report of Special Board on Canal Connecting Lake Erie 
with Ohio River, 67th Congress, 22d Session, House Doc. No. 188, p. 30. 

a Data on investment, tonnage, and operating expenses from reports of New 
York Superintendent of Public Works. Interest plus depreciation reckoned at 
6 per cent on $170,000,000. 

3 Based on figures for 1921. 




















316 


ECONOMICS OF OVERHEAD COSTS 


$2.oo. f Traffic must increase greatly before the canal can show 
a real economy. 

One further benefit which has bulked large in the minds of 
those responsible for waterway construction is the reduction of 
rail rates by water competition. This method of controlling 
rail rates, though expensive, is effectual, and may have been 
worth its cost in the days before the Interstate Commerce 
Commission acquired its present powers over the general level 
of railroad earnings and before the size and cost of waterways 
grew to its present huge proportions. Now, however, with 
rail rates regulated toward a general level yielding 6 per cent on 
investment, the chief effect of water competition is to cheapen 
some hauls at the expense of others, creating differentials in 
favor of localities which benefit from water competition, actual 
or potential. It is more than doubtful whether any community 
benefits which arise are worth the heavy overhead cost. 

In general, a modern large canal capable of carrying i,ooo-ton 
barges or 3,000-ton tows, costs several times as much as a railway 
of similar capacity, so that its disadvantage in overhead cost, 
coupled with terminal handicaps, is likely to be decisive. 

7. CONCLUSION 

It is quite possible to have an adequate and economical 
transportation system, in spite of the difficulties created by the 
laying of overhead costs on the public treasury. There are 
several essential requirements of a sound policy. One is careful 
and conservative surveys of costs and benefits before deciding 
on construction. Another is control of traffic so that it may not 
be necessary to build wastefully heavy roads in order to avoid 
wastefully heavy wear and tear. A third is that burdens should 
fall where the benefits accrue, largely in the shape of yearly fees, 
but partly in charges varying with use, so that this essentially 
industrial service of government shall not, under the increased 
demands made by motor transport, eat up the revenues needed 
in ever increasing amounts for non-industrial services which 

1 Based on figures given in bushels and 100-lb. units in Report of New York 
Superintendent of Public Works, on Canals, 1921, pp. 10 and 20. 


TRANSPORTATION SYSTEM AS A WHOLE 


317 


cannot as fairly be made self-supporting as the highways. And 
lastly, highway bonds should obviously not outlive the highways, 
if ordinary foresight and caution can prevent this, and in any 
case the cost of roads should be charged with the depreciation 
which actually occurs, not the amortization charges on the bonds. 
With this brief survey of problems of overhead cost in transporta¬ 
tion, we must now turn for a moment to another class of industries 
where problems of overhead cost appear in an even more inter¬ 
esting and characteristic form, namely, the “public utilities.” 


CHAPTER XVI 
PUBLIC UTILITIES 


SUMMARY 

Introduction, 318—Economies of size, 318—Load factors and the allocation 
of costs, 322—Service and rates, 323—Building ahead of demand, 330—Fair 
return and the incentive to efficiency, 332—Conclusion, 334. 

I. INTRODUCTION 

The term “ Public Utilities” is commonly applied to companies 
furnishing a community with such things as water, gas, electric 
current, or telephone service. Street-car lines are also in¬ 
cluded, but will not be discussed here. These services exhibit 
all the problems of overhead cost, and in extreme forms. They 
have large capital investments, of a highly specialized kind; 
they show marked economy with size (except for telephone 
companies) and with intensive exploitation of their localities; 
they have strongly marked daily and seasonal peaks and some 
of them have developed definite policies looking toward mini¬ 
mizing the wastes involved; and they face difficult questions 
in allocating their overhead costs to different types and classes 
of business. In the sale of electric current, in particular, there 
have been developed the most systematic mathematical methods 
found anywhere for differentiating charges according to factors 
affecting the company’s peak load. These systems of rates 
involve principles deserving of serious study by other businesses, 
with a view to adapting them to their own peak-load problems. 

2. ECONOMIES OF SIZE 

The causes of increased efficiency with increased size in the 
supply of electric current are admirably summarized by Paul M. 
Lincoln, who groups them under three main heads. 1 First is 

1 Proceedings , American Institute of Electrical Engineers , 1913, pp. 1937-43. 
In Mr Lincoln’s address as president of the Institute, two years later, he discussed 
growth in size of plants, among other features of electrical development. 

318 


PUBLIC UTILITIES 


319 


the fact that larger units of equipment cost less per unit of 
capacity; second is the reduction of operating expenses, and 
third is the fact that the greater the number of customers, the 
more do their individual irregularities neutralize each other, 
producing a better load factor for the plant as whole than the 
average of the individual load factors, and a better load factor 
for a large plant than for a small one. Over against these savings 
stand the elements of increasing cost in the distributing system, 
and increasing losses in transmission. The reduction of operating 
expenses is partly due to the fact that larger output makes it 
economical to instal more and more labor-saving devices, and 
in order to secure these gains investment must increase more 
than would be necessary merely to reproduce on a large scale 
the identical mechanical units and the identical physical services 
rendered by smaller plants. And as a further result, operating 
expenses per unit produced diminish even more than investment. 

The economies of larger units—boilers, generators, and 
transformers—Mr. Lincoln represents by straight lines sloping 
downward on a double logarithmic scale. Translated into a 
natural scale, and into terms of total cost, these become curves 
ascending at an ever diminishing slope. With boilers, he esti¬ 
mates that a tenfold increase in capacity yields a 40 per cent 
economy, so that one could get ten times as large a boiler for 
six times the cost. With generators, he estimates that a tenfold 
increase in size brings a 65 per cent economy allowing for equal 
speeds, so that the larger generator would cost only three and 
one-half times as much as the smaller. With transformers the 
saving runs from 65 per cent on 22,000-volt transformers to about 
77 per cent on no,ooo-volt instruments, so that one could get 
ten times as large a transformer of the no,000-volt type for only 
two and three-tenths times the cost. And since a 10,000-kilowatt 
turbo-generator requires little more space than one of 1,000 
kilowatts, there is another large economy in housing the plant. 

Further material savings are secured from superheaters and 
economizers, which save about 10 per cent of the fuel, and whose 
relative cost decreases as the size of the plant increases; also 
condensers, feed water heaters, water-softening plants, me- 


320 


ECONOMICS OF OVERHEAD COSTS 


chanical stokers, and other machinery for handling coal and 
removing ashes, and other devices. He also mentions the 
screening of fuel, and the securing of a guaranteed and uniform 
fuel supply by purchasing under specifications—an advantage 
available only to large buyers This last is an excellent example 
of intangible overhead. As for labor, Mr. Lincoln mentions that 
a 10,000-kilowatt generator requires little more attention than 
one of ioo kilowatts, the number of bearings being similar. 
This item of labor is clearly a “constant cost,” while all the labor- 
saving devices already mentioned have their natural effect 
on the wage-bill. Furthermore, the large plant can have not 
only larger units but more of them, and thus gain flexibility, 
being able to run at different rates of output while the working 
units are always running near the rate which brings maximum 
economy. There are definite objections to trusting as much as 
one-fourth of the load to a single machine. 1 

As one might expect from this list of savings, the figures of 
cost show a decided economy with size, even in the case of quite 
large plants. 2 With gas, the case is somewhat different, as the 
economies of size appear to be exhausted before the very large 
plants are reached. H. G. Barker, in his Public Utility Rates , 
tabulates the operating expenses of seventeen plants of over 
500,000,000 cubic feet output, and seventy-six smaller plants, 
of less than 300,000,000 cubic feet. 3 The smaller plants show 
cost increasing at a decreasing rate in a well-marked curve. In 
fact, the curve y= Vx* fits the points quite remarkably well, 
where y is cost in tens of thousands of dollars and x is output in 
tens of millions of cubic feet. For the larger plants, the down¬ 
ward curvature disappears and the trend is to all intents and 
purposes a straight line: y = .\2x-\-k, k being so small as to be 
negligible in comparison with the large totals. In other words, 

1 See Report of National Electric Lighting Association Committee on Prime 
Movers, 1919. 

2 See Report , Wisconsin Railroad Commission 1916, pp. 640-41, 676-77, for unit 
costs of companies of class A and class B in that state. 

3 H. G. Barker, Public Utility Rates, pp. 297-99. Two of the smaller plants 
are in large cities and are grouped by Barker with the larger plants. 


PUBLIC UTILITIES 


321 


operating expenses of large plants average 42 cents per thousand 
feet, with no perceptible savings from greater size. These figures 
behave so like those of railroads that the coincidence is striking. 
The reader will remember that the curve of operating expense 
showed a slight downward curvature for roads of_small traffic 
density, agreeing fairly well with the curve: y — l^x 4 ; but losing 
all visible curvature as the traffic densities became larger. 

Telephone companies, on the other hand, show no signs of 
economy with increased size, but rather the opposite. Figures 
published by the Wisconsin Railroad Commission indicate that 
in terms of operating expense, the most economical size is from 
350 to 1,500 telephones, while the lowest capital cost falls between 
300 and 1,000 telephones, and the combined cost appears to 
average least for plants of from 300 to 1,250 instruments. 1 The 
cost for Milwaukee was about double the average for this group, 
while for Madison it was more than one-third in excess. For 
the smaller plants there is also a much wider range of variation 
in cost than the larger plants show; perhaps because the personal 
equation has more scope. 

This increase of cost with size does not necessarily measure 
the cost of consolidating all the telephones in a given community 
under one organization, since rival companies would have to 
duplicate a great deal of the cost of the distributing system. 
However, the decisive element in favor of consolidation is not 
cost, but service. And in apparent defiance of the facts as to 
costs, those in the telephone business appear to consider that 
added business may increase earnings more than it increases 
expenses, even though it does not cover its pro rata share of 
overhead. With the data at hand it is impossible to say whether 
this represents an example of the short-run point of view, where 
a plant, for the moment, has spare capacity; or whether it is 
a fair long-run estimate of the cumulative benefits of increased 
business. As it stands, it represents an interesting and rather 
typical paradox in economic judgments. 

1 Report, Wisconsin Railroad Commission, 1916, pp. 348-51, 370-73. Com¬ 
bined cost estimated by the present writer on the basis of operating expense plus 
7 per cent on cost of plant and equipment. 


322 


ECONOMICS OF OVERHEAD COSTS 


The introduction of automatic telephone exchanges is an 
interesting innovation, involving an enormous investment, a 
corresponding reduction of direct operating expense, and an 
investment in machines-to-make-machines which looks a gener¬ 
ation ahead. This device—a mechanical marvel suggesting a 
magnified human brain and nervous system—shifts the emphasis 
from work of operation to work of maintenance, renewal, and 
extension, which now becomes the chief variable element in 
costs, and requires foresight and careful scheduling to avoid the 
vicious irregularities which play so large a part in the business 
cycle and lay so heavy a burden upon industry. 

3. LOAD-FACTORS AND THE ALLOCATION OF COSTS 

Public utilities are subject to both daily and seasonal rhythms, 
though gas plants dispose of the daily peak by storage, and thus 
do not need producing capacity equal to the highest momentary 
rate of use. However, the distributing system must provide 
capacity for the daily peak, not merely for the daily average. 
These rhythms are to some extent subject to control, but within 
fairly definite limits. The fundamental habits of people’s lives 
will not be changed by rate systems, but they may learn to 
cook with gas, or to use electric vacuum cleaners in the home, 
while factories will use whatever power is cheapest, and will 
accept restrictions on its use if it is made worth their while to 
do so. The chief purposes of a rate system should be to earn 
a reasonable total return, to develop the utmost use of the 
facilities so long as every service pays at least its differential 
cost, and to distribute residual costs fairly according to the 
responsibility of different users for the amount of these costs. 

The expenses of a public utility vary with many things. The 
investment in the central station depends upon the capacity 
required, and this depends upon the maximum demand the 
plant expects to have to meet, with the proviso that it pays to 
build large enough to take care of some years’ growth, rather 
than be continually rebuilding. The investment in the distri¬ 
bution system depends jointly upon the distance which has to 
be covered and the maximum demand which each part of the 


PUBLIC UTILITIES 


323 


system has to be prepared to meet. Here, too, it is economical 
to build ahead of growth, in moderation. Coal consumed, 
and some elements of wear and tear, depend upon output; 
while the costs of billing, meter reading, and investment in 
meters depend more nearly on the number of consumers than 
on any other factor, though certain classes would require more 
expensive meters. 

However, the “capacity” expenses do not necessarily vary 
in exact proportion to capacity, for there is, as we have seen, 
an economy in plants of large capacity so that cost does not 
increase pro rata. These costs may depend on maximum 
demand, but a 5 per cent increase in maximum demand may 
typically necessitate only a 4 per cent increase in the “capacity 
costs.” 1 Then any given unit of business is self-supporting so 
long as it pays four-fifths of its pro rata share of the capacity 
costs. And if the plant has spare capacity, then business need 
not pay any of the capacity costs in order to be self-sustaining. 
As for the output expenses—those which vary with output— 
daily fluctuations will produce one kind of variation in them, 
seasonal fluctuations another, and long-run growth still another. 
Output expenses are, of course, reduced to their lowest terms in 
hydroelectric plants, but are fairly substantial where plants burn 
coal. 

4. SERVICE AND RATES 

No rate system can take account simultaneously of all these 
elements, and any elements which the rate system cannot afford 
to consider may fairly be ignored. Rate systems must be 
simple enough for the consumer to understand their general 
reason for being, while regulating bodies sometimes impose 
limitations on the companies’ freedom in devising rate systems. 
For instance, it is practicable to differentiate electrical rates 
according to the user’s daily load-curve; therefore, the daily 
fluctuation of output costs is worth considering. On the other 

* This 4 per cent need include only expenses made necessary to handle a possible 
increased demand, not labor-saving devices made profitable by an increase in output. 
The latter are really output costs, partly offsetting the decrease in operating 
expenses per unit of service, which results from increased size. 


324 


ECONOMICS OF OVERHEAD COSTS 


hand, if it were decided that it was impracticable to make seasonal 
rates to stimulate business at the low seasons of the year, then 
the seasonal variation of output cost would be irrelevant. In 
gas plants, it may be difficult to make rational allowance for 
the daily peak, or to stimulate off-season business effectively, 
in which case a conservative management might fall back on 
the fact that a general growth of output, without any change 
for better or for worse in its daily or seasonal distribution, 
ought always to pay its full share of the long-run differentia 
costs of increased output. Probably it would be fair, even in 
electrical concerns, to make every class of general business pay 
at least this much, though current taken at off-peak hours might 
claim a lower minimum. 

A rate system is primarily governed by practical considera¬ 
tions. If added use costs the consumer more than it costs the 
company, there is a probable failure to develop services which 
would be worth their cost. If added use costs the consumer 
less than it costs the company, there is a stimulus to wasteful 
use. And if the concern is in the stage where costs decrease 
with increasing size, then charges made according to the foregoing 
principles would not yield the necessary income, and the company 
must charge more, preferably where it will have the least effect 
in limiting use. In other words, it should follow the principle 
of “ charging what the traffic will bear” in the best meaning of 
that much-abused phrase. 

The most logical system based on costs would be to charge 
each customer a lump sum to cover the entire amount of the 
“consumer costs,” or costs which are governed by the number 
of consumers. This charge would be uniform to all consumers, 
or to all in a. given class. Then each would pay a “readiness- 
to-serve” charge, covering at least the differential portion of the 
capacity costs, and divided up according to the consumer’s 
share in the maximum demand which falls on the central plant, 
so far as that can be determined. 1 This would not be an infallibly 

1 The “readiness-to-serve” principle is familiar as a basis for electrical rates. 
The “Hopkinson rate” is the most used form of rate for large consumers, and is 
made up of a charge of so much per kilowatt of maximum demand and another 



PUBLIC UTILITIES 


32$ 


just standard, but probably as good as could be devised. To 
this would be added an output charge covering all the differential 
costs of output. If the utility is so large that there are no more 
economies to be had from further growth, then this system of 
rates will cover all its costs. But if it is in the stage of decreasing 
costs with increasing size, then there will be some residual or 
constant costs which must be divided in whatever way seems 
just or expedient—probably according to “what the traffic 
will bear.” 

The critical features of this method of rate-making are: 
the arranging of the rate so that the charge for additional use 
covers only the output costs, the covering of capacity and con¬ 
sumer costs in a way which does not fall as a burden on additional 
use, and the fixing of, differential costs as a minimum, with 
liberty to apportion residual costs on principles of justice and 
expediency. The first principles are definitely recognized in 
modern electrical rate systems, while the third makes itself felt 
with quite sufficient force, whether it is recognized as part of the 
system or not. Manufacturers who could generate their own 
current are in a position to secure the lowest rate the utility 
can make, above differential cost, while smaller consumers 
have no such bargaining advantage. 

The form of the rate system varies. Sometimes the con¬ 
sumer and capacity charges are merged. Where the company 
does not wish to make separate charges for “ readiness-to-serve,” 
or is not allowed to do so, the same result is approximated by 
making a heavy initial charge for current, so that even fairly 
small users shall pay their capacity costs, and then changing 
to a lower rate for additional current after the consumer has used 
sufficient to pay for his capacity costs, whatever they may be. * 1 
Thus the point at which the lower rate begins needs to be carefully 

charge of so much per kilowatt-hour used. See Watkins, Electrical Rates , pp. 50-52 
and elsewhere. Watkins notes that rate schedules do not explicitly take account of 
anything but the amount of the consumer’s maximum, ignoring the way in which 
it fits into the load-curve of the entire system. 

1 This form of rate is known by the name of its inventor, Mr. Arthur Wright, 
and is the commonest form of load-factor rate, especially for small consumers. 



326 


ECONOMICS OF OVERHEAD COSTS 


adjusted, so that the system may be something more than a 
mere discount for quantity used. Where the capacity of the 
consumer’s fixtures is taken as the index of his share in capacity 
costs, he gets the lower rate after the equivalent of, let us say, 
thirty hours’ continuous use of his total capacity. Thus he 
can lower his rate without using any more current, by reducing 
the number or size of his fixtures and consuming the same amount 
of current as before. But this would not ordinarily result in 
lightening the company’s burdens materially, since the consumer 
will protect himself by doing without fights in closets, cellars, 
and other places where they are little used, and the result will 
be little reduction, either in the peak or in the average load. 
For this reason other indexes are sometimes used, such as floor- 
space or number of rooms. 

One of the most difficult parts of such a rate system is the 
choice of an index of the consumer’s responsibility for the capacity 
costs. In some cases the consumer makes a special contract 
by which he uses current only at off-peak times. Here the 
consumer’s share of capacity costs is nothing at all. At the 
opposite extreme is “breakdown” or emergency service, where 
virtually the entire cost is on account of “readiness to serve,” 
and actual output may be next to nothing. A city’s demand 
for water for its fire hydrants is of this sort; it is responsible for 
a large part of the investment of a water company, though the 
amount of water actually taken is relatively insignificant. The 
increased investment is chiefly in the distributing system. 
The necessary capacity of reservoirs is not greatly increased, 
though a central pumping station may have to be made larger 
to be sure of being able to furnish the necessary flow. It would 
not be absolutely necessary, however, to provide for the largest 
conceivable demand, since private consumers could be shut off 
in the event of some great conflagration. Here a rather high 
grade of judgment is evidently required in estimating the invest¬ 
ment which is really called for in order to provide for such demands 
for intermittent service. 

Between these two extremes stands the typical consumer, 
who uses the service fairly regularly but not with absolute 


PUBLIC UTILITIES 


32 7 


uniformity, and whose demand comes partly on the peak and 
partly off. 

One index of his share of capacity costs is the total capacity 
of his fixtures. This might be fairly just as betweeen members 
of a homogeneous class of customers, but would be very unfair 
as between different classes. However, if a better measure is 
found for allotting the burden between residences and drug-stores, 
for example, capacity of fixtures may do fairly well to divide 
up the class burden among the members of the class. Another 
test is the consumer’s maximum demand. This can be recorded 
by meters built for the purpose, but it is not considered economi¬ 
cally practicable to do this for residence consumers. 1 Further^ 
more, the demand that counts is the demand at the time of the 
peak load on the central station. 2 This also can be recorded by 
a dual meter, or the meter can be arranged to run faster between 
certain hours, but these methods do not appear to have made 
their way into permanent use. 3 In the nature of the case, the 
greater part of the trade is extremely likely to come from 
customers whose individual peaks come at about the same time 
as the peak on the central station. 

No one index is best for all cases. It depends on the number 
and size of the customers in a given class, on whether their 
individual peaks come at the same time as the central station 
peak or not, and on whether the individual customer is in a posi¬ 
tion to control his requirements for peak service, if he is given a 
chance to gain thereby. The mechanical recording of actual 
maximum demands, or of demands at the time of the central 
station peak, is an inaccurate basis of rate-making for small 
customers. For the chief significance to the company of the 
past performances of their customers is as evidence of the maxi¬ 
mum load they need to provide against in the future. It is 
useless for this purpose unless behavior is consistent enough 
to make it possible to judge the future by the past. Large 

1 See Watkins, op. cit., p. 137. 

* Ibid., pp. 50-51. A recent development is the meter which graphically 
records the entire load-curve, and this probably has a wide field of usefulness for 
large consumers. 

3 Ibid., p. 56. 


328 


ECONOMICS OF OVERHEAD COSTS 


consumers or classes of consumers behave consistently, but single 
small customers are governed too much by chance. A careful 
study of their individual habits of consumption would make it 
possible to judge what their proper share in the total peak burden 
is, but a single day’s maximum peak means very little. An 
average for December and January would mean a great deal 
more, and might work fairly just results. 

In general, however, the exact method of determining peak 
responsbility is not so important as it is to exempt from capacity 
charges additional service which comes wholly or mainly off 
the peak. The practical improvements resulting from scientific 
rate systems have come not so much from limiting peak demands 
by penalizing them with heavy charges as from developing off- 
peak business by freeing it from the burden of overhead. This 
has been done partly by granting low rates for additional current 
on such terms that the extra demand must come, in the nature 
of the case, mostly at off-peak hours. For example, the ordinary 
residence will not use current for lighting more than a certain 
number of hours in the day. To increase the average number 
of hours’ use, current must be used for cooking and household 
machinery. And while some of this service may come on the 
peak, the net effect will be to increase the ratio between average 
output and maximum demand. One way of making concessions 
to stimulate this kind of business is to sell appliances at low prices, 
taking the profit in the charge for current used. This applies 
to gas as well as electricity. It has its undesirable side, since 
it gives the company an incentive to discriminate in favor of 
appliances which are not too economical of gas or electricity, 
so that it is probably better, in the long run, not to use one 
operation to subsidize another, but to let each stand on its own 
feet, provided a really scientific system of rate-differentiation 
can be worked out and applied. 

However, it is in the development of power for industrial 
purposes that the greatest gains in off-peak business have been 
made. The experience of one large eastern industrial center in 
this respect is striking. 1 In 1907 there was a sharp peak between 

1 See Watkins’ Electrical Rales, p. 22. 


PUBLIC UTILITIES 


329 


five and six o’clock in the evening, amounting to more than 
double the average day-time rate of consumption. Gradually 
there was built up an all-day demand, until the former peak 
actually disappeared, its place being taken by a plateau lasting 
from eight in the morning till six at night, with variations of 
little more than 20 per cent, the actual summit often coming 
between nine and ten in the morning. With this change went 
a steady improvement in the load-factor from 50 per cent in 
1907 and 1908 to an average of 71.5 per cent for the years 1917 
to 1920, with a maximum of 82 per cent in 1918. In this war 
year, current was used in large amounts until ten o’clock at 
night, probably on account of plants working overtime. And 
it was this evening demand which made possible a total output 
which was 82 per cent of what it would have been if demand 
had been uniform throughout the twenty-four hours. This is 
probably too high a load-factor: too high, that is, for the best 
results in terms of all the human factors involved. But it illus¬ 
trates forcibly what can be done by developing ail-day uses. 
During all this time the five-o’clock demand continued growing, 
and was about five times as great in 1918 as in 1907, so that it 
appears that these results were not accomplished by compressing 
the peak but by expanding the business done during the rest of 
the day. 

In telephone service the most definite example of rates to 
develop off-peak business has been in the long-distance service, 
where night rates have been established. These have had the 
effect of building up subsidiary peaks, the customers tending 
to put in calls as soon as possible after the reduced rate goes into 
effect In general, the fixing of rates for different classes of 
service involves difficult questions of justice in apportioning 
overhead costs. Business traffic is more steady during the day 
than residential traffic, which tends to concentrate during the 
after-breakfast and after-dinner hours, but on the other hand 
business demands a higher speed of service, the benefits of which 
are necessarily extended to residential users in considerable 
measure. For these and other reasons, the allocation of costs 
between different classes is a matter of judgment and hypothesis, 



330 


ECONOMICS OF OVERHEAD COSTS 


in which the results may differ according to which of two hy¬ 
potheses are used, both being equally plausible. 

Telephone companies naturally desire to develop business, 
and are willing to make low rates to attract users who cannot 
afford the rates which other users pay. This must, of course, 
be done under the form of a different class of service, such as a 
four-party or an eight-party line. Here the range of possible 
discrimination is limited. A company might be willing to 
instal cheap classes of service at greater reductions in rates than 
their relative cost by itself would justify, if they could thereby 
attract new business and only new business. But many existing 
customers will shift to the new and cheaper classes if the induce¬ 
ment is substantial, and it is not easy for a regulated public 
service company to make the quality of the cheaper service 
intentionally unattractive with the deliberate purpose of pre¬ 
venting the users of more expensive services from shifting to 
the new class, and so securing the concession which was meant 
to develop new trade and new trade only. 

Thus the principle of “charging what the traffic will bear” 
cannot be utilized to its fullest extent by telephone companies. 
Perhaps the clearest economic principle applying to telephone 
rates is the rule that additional calls, beyond the usual minimum, 
should cost the subscriber approximately as much as they add 
to the cost of the company. A flat rate of so much per month 
for unlimited service tends toward wasteful use, and a uniform 
charge of so much per call may hinder the profitable extension 
of business. The uniform charge with a monthly minimum 
combines the bad features of both, and is only justified on grounds 
of physical convenience. 

5. BUILDING AHEAD OF DEMAND 

Where demand is growing, it is only common sense and reason¬ 
able economy to build in anticipation of its growth, with the 
result that some parts of the plant, at least, have more capacity 
than is needed for present business. Maintenance, insurance, 
depreciation, and interest on this excess capacity are costs, but 
costs of what? Are they costs of present business or deferred 


PUBLIC UTILITIES 


331 


charges against future business ? If deferred charges, how should 
their amount be measured and what should be the attitude of 
regulating bodies when the time comes for the company to realize 
on its foresight? The accounting procedure involved in this 
question is beyond the scope of the present study, but the princi¬ 
ples underlying it can be formulated in general terms. 

The sum of costs over a term of years, both operating expenses 
and capital charges, will be diminished if the company builds 
sufficiently far in advance of demand, and increased if it builds 
too far in advance or not far enough. The exact point depends 
on the rate of future growth, and is therefore uncertain, so that 
no one can determine in advance the exact best size, and some 
risk is necessarily involved. This risk may be either assumed 
by the public or laid upon the company; that is, the company 
may be held to be entitled to recover a fair return on whatever 
it has spent, or the public may be held to be entitled to the benefit 
of reasonably good judgment on the part of the company, so 
that the company might suffer a loss if it built unwisely. If this 
latter policy is followed, it is reasonable to give the company 
a corresponding chance of profit if its judgment proves to have 
been unusually good. 

In any case, it is unfair to make present consumers pay all 
the idle overhead incurred for the sake of providing for the 
future business in the cheapest possible way. The cost of present 
business should be so calculated that with reasonable growth 
its burdens will be the same as those of future business, and the 
amount of the deferred charge should be large enough to bring 
about this uniformity. Both present and future business should 
pay more than a bare return on the capacity they actually use, 
and the idle overhead should be evenly distributed between 
them, so long as it does not exceed a reasonable amount. As 
to what is a reasonable amount, this should be determined by 
investigation of the experience of different classes of communities, 
showing the typical rates of growth, the costs of inadequate 
provision for the future, or of unduly great provision, and the 
savings possible from a wise policy. With very large communi¬ 
ties, it would probably prove possible to make the plant so 


332 


ECONOMICS OF OVERHEAD COSTS 


flexible that the troublesome element of idle capacity and 
deferred charges could be reduced to very small proportions, 
and it might even be disregarded altogether. 

The general rule of regulation is that the company is entitled 
to a fair return on all investment used and useful for the service 
of the public, but this should not be construed to mean a return 
only on the capacity which the public requires for the business 
of the present year only. A certain amount of idle capacity is 
normally “used and useful,” let us say, in 1923, in providing 
for future traffic in the cheapest way possible; and after that 
traffic materializes—say in 1926—it is receiving the benefit, 
not merely of the interest, depreciation, etc., actually accruing 
in 1926, but of a certain amount of unabsorbed charges accruing 
during the preceding years. This is an extension of the well- 
known principle developed by the Wisconsin commission that a 
“fair return” includes compensation for deficits due to the 
inevitable period of development which such businesses must 
go through. 

Since it appears not only natural but desirable that a company 
should carry, a large part of the time, capacity beyond the 
demands of the business of the moment, it seems to follow that 
it should be free to minimize the burden of unearned overhead 
costs by making low rates to develop additional business which 
may utilize this capacity, with the understanding that this 
creates no permanent obligation and that these rates may be 
raised when regular business expands to the point of requiring 
the full capacity of the plant. Such rates would be difficult 
to administer, but are justified, at least in theory, by the facts 
of the case. 

6. “fair return” and the incentive to efficiency 

Thus we come to the general question of “fair return” in 
regulated companies and its relation to efficient management. 
This question transcends the bounds of a study of overhead 
costs, and is too large to be treated here. Yet the preceding 
discussion reveals facts which have an important bearing upon 
it. We have seen that efficiency is not merely a technical matter; 



PUBLIC UTILITIES 


333 


it includes a knowledge of differential and residual costs, and 
requires the scientific classification of service and rates so as to 
promote the best use of the facilities at hand, and a wise policy 
in the matter of building for future growth. It also includes 
correct decisions as to when existing plants should be abandoned; 
when new machines should be installed; when a railroad line 
should be relocated; when a power-house should be moved to a 
cheaper location, etc. Even if the requirements of technical 
efficiency could be determined and standardized by a regulating 
body, these economic requirements would remain, and would 
offer still greater difficulties. The regulating body can hardly 
be expected to set up standards of efficiency in all these matters 
and enforce them upon the company. 

This being the case, progress will be promoted if the company 
has some chance to secure the rewards of pioneering in the shape 
of a profit, reasonable in amount and limited in time. There 
is danger in limiting the company’s return too rigidly to its 
overhead costs as shown in the accounts. This principle shows 
itself forcibly in determining the point at which existing property 
should be abandoned and its value written off the books. When¬ 
ever new equipment can reduce the total costs of service enough 
to pay its own overhead, disregarding any irrecoverable costs 
represented by the old equipment , the old equipment has lost its 
value: depreciation has already occurred. If a commission 
could always determine when this had happened, it could write 
this amount off the books, and then the company would have 
nothing to lose by making the change. But the commissions 
are not in a position to do this: they must ordinarily wait until 
the company tries the experiment and reveals the facts. If they 
then penalize the company, it is penalized not for the depreciation 
but for recognizing it and making it good—an outcome which 
tends to put a blight on the necessary modernizing of plants. 

The differential cost to the company of such modernization 
should not be swollen by a capital loss for which the moderni¬ 
zation itself is not responsible. This is a real dilemma, and points 
toward the provision of reserves to take care of such contingencies. 
Where such reserves have not been provided and the contingency 


334 


ECONOMICS OF OVERHEAD COSTS 


arises, it is the part of wisdom to give the company an extension 
of time in which to write off the value of its obsolete property. 

7. CONCLUSION 

The questions covered by this chapter are so varied that no 
simple summary is possible. It is evident that efficiency is a 
matter not merely of smooth-running machines and economical 
arrangement of floor-space but of economic analysis of the facts 
of differential and residual costs, both in their short-time and 
their long-time aspects, as affected by daily and seasonal fluctu¬ 
ations, by growth in size of plants and by the irrecoverable 
costs of abandoned property. The requirements of efficiency 
call not merely for a high grade of intelligence but for a broad- 
gauge grasp of economic principles and the ability to feel one’s 
way sanely through experimental solutions where no preconceived 
formula can serve as an absolute guide. 


CHAPTER XVII 

OVERHEAD COSTS IN OTHER INDUSTRIES 

SUMMARY 

Introduction, 335—General manufacturing, 337—Merchandising, 339— 
Agriculture, 343—Coal Mining, 347—Overhead costs in public services, 352— 
Overhead costs in “consumption,” 354—Conclusion, 355. 

I. INTRODUCTION 

If one asks the question: “How large an element does 
overhead cost constitute in industry in general?” the answer 
is not so simple as one might expect, on account of the different 
varieties and aspects of overhead cost. And if one were to under¬ 
take a survey of the field, industry by industry, one would find 
different aspects emphasized in different industries. It will be 
worth while, therefore, to make out a rough outline of the subjects 
which such an inquiry must cover. Such an outline will inevit¬ 
ably contain a deal of cross-classification, since overhead costs 
may be divided according to the productive factor concerned— 
capital, labor, materials, or knowledge and organization; accord¬ 
ing to the type of variation considered—long-run growth, 
mobilizations of productive energy from industry to industry, 
and seasonal, cyclical, or other fluctuations of activity; according 
to the facts of physical production or the character of financial 
obligations; and according to the person or agency which bears 
the burden and responsibility—for it may fall on the business 
enterprise directly concerned, on other business enterprises, 
on employees, on the public as individuals, on business associa¬ 
tions, or on government. In the outline which is here presented, 
no attempt will be made to follow this four-dimensional scheme 
with strict consistency, as that would make the framework 
unnecessarily complex, and the reader will readily recognize 
which basis of classification is being used in each heading. 

1. First and foremost comes the question of the amount of 
invested capital in an industry: ( a ) total investment, ( b ) perma- 


33S 


336 


ECONOMICS OF OVERHEAD COSTS 


nent equipment, ( c ) specialized and immobile equipment, ( d) 
investment covered by funded debt or other forms of fixed 
financial obligation, such as leases, and ( e ) the surplus capacity, 
if any, above the amount required to satisfy the demand, includ¬ 
ing the average demand, the maximum of daily or seasonal fluc¬ 
tuations, and the maximum of the business cycle or the capacity 
required to sustain the peak of business prosperity. This survey 
of invested capital throws light on the size of the necessary 
margin above operating expenses: whether necessary to legal 
solvency, necessary to the immediate continuance of operations, 
or necessary to long-run economic soundness. It should be recog¬ 
nized that the mobility of capital is a relative thing and that the 
loss involved in mobilization, which may be regarded as a form 
of “sunk cost,” grows less as the time allowed for mobilization 
grows greater. So far as factors can be mobilized, the costs 
they represent are differential costs of output, but with many 
of the short-run fluctuations, mobilization is impossible, and 
these costs must then be treated as constant. 

2. Almost equally important is the investment in materials, 
analyzed with reference to the risk the company runs of being 
caught with them on its hands in a falling market and being 
forced to write off part of their original cost as irrecoverable. 
Another important fact about materials is that while their cost is 
a direct expense to the business which uses them, it contains or 
reimburses the overhead costs of those who produced them. 
To an integrated concern, a large part of the cost of its materials 
would be overhead. This difficulty can be met by counting 
only the “value added to materials” and the cost of adding that 
value, but materials cannot be wholly ignored, since some of the 
costs of working them up depend upon their amount, character, 
and value. 

3. The economies ( a ) of size, ( b) of horizontal combination, 
and (c) of vertical combination. 

4. Joint costs: that part of the total cost of a series of comple¬ 
mentary products which cannot be traced to any one of them. 

5. The responsiveness of costs to fluctuations, daily, seasonal, 
and cyclical. This depends partly upon the facts of invested 


OVERHEAD COSTS IN OTHER INDUSTRIES 


337 


capital, but even more upon the character and behavior of the 
operating expenses, both indirect and direct. 

6. Intellectual overhead: the “state of the arts” or the 
commercial and technical knowledge essential to efficient produc¬ 
tion, so far as it is limited by economic forces or appropriated 
as wealth by private interests, or so far as it requires economic 
efforts to conserve it, propagate it and extend its boundaries. 
The extent, importance, and costliness of this element in produc¬ 
tion is no less significant than the manner of administering it. 
Is it private property or a public good? Is it cared for by 
individual producers, by voluntary associations, or by local or 
national governments ? 

7. If not already covered under the preceding heading, there 
would be the further question: To what extent does the industry 
benefit by public services of a special sort? Such services are 
mostly concerned with industrial and commercial knowledge— 
the bureau of standards tests materials, the bureau of mines 
experiments with safety devices and methods, the department 
of agriculture publishes the results of a wide variety of studies, 
while agricultural experiment stations and demonstration farms 
engage in research and education for the good of the farmer, and 
members of Congress distribute seeds. Aside from this last 
political anachronism these are all of the nature of scientific 
development of methods of production, and broadcasting of the 
results as widely as possible, for the benefit of individual small- 
scale producers who could not possibly do this for themselves. 

8. Last but not least, would come a study of the extent to 
which labor partook of the nature of an overhead cost; first to 
the individual employer; second, to the industry at large; 
third, to the laborer himself, and last, to the community as a 
whole. This entire matter of labor will require a chapter by 
itself. 

2 . GENERAL MANUFACTURING 

It is, of course, impossible to generalize about anything so 
vast and varied as modern manufacturing, ranging as it does 
from the billion-dollar steel merger to the tiny shop where a girl 
weaves scarves by hand for those who can pay the price. One 


33^ 


ECONOMICS OF OVERHEAD COSTS 


important symptom is the ratio of capital to annual output 
(in terms of “value added to materials”)* Mr* Oswald Knauth’s 
analysis of the census figures shows that the average value 
product of manufacturers was 46 per cent of the capital in 1910, 
while at one extreme stood a group of twenty-five industries 
whose value product averaged 103 per cent of the capital and at 
the other extreme a group of twenty-one industries whose value 
product averaged only 17.5 per cent of their capital. By com¬ 
parison, the value-product of railroads was 19.5 per cent of the 
capital, or 14.4 per cent if “materials, supplies, etc.,” are omitted. 

Thus the manufacturing plants of heaviest capital investment 
are about on even terms with railroads. The list includes blast 
furnaces, lead smelting and refining and manufacturing lead for 
pipe and sheet, coke, gas, cement, malt, petroleum refining, 
sugar refining, and moving pictures. In general, the list shows 
marked similarity to the fist of industries in which three-quarters 
or more of the output is made in large plants, i.e., plants of 
more than $1,000,000 annual output. Evidently large propor¬ 
tions of capital to labor and large size of plants are related—each 
is partly cause and partly effect. 

As for materials, conditions vary so much that little need be 
said save that the average outlay is several times the annual out¬ 
lay for labor, which means that the average concern, besides its 
own overhead in the shape of return on investment, is paying 
for a still larger aggregate of overhead costs incurred by those 
who make the materials it uses. Another way of putting it is 
to say that a majority of all the overhead costs of industry are 
incurred in producing things which others use as materials, and 
must be shifted onto those who use the materials. But to 
the latter, these are not overhead costs, but direct and variable 
costs. In being shifted, they have been converted from one 
form to another. 

The elasticity of expenses also varies so much that it is hardly 
possible to generalize beyond the fact that expenses vary far 
more in the long run than over short periods, and that in the 
short run, operating expenses probably vary in typical cases 
from half to three-fourths as much as output, up to the point of 
congestion. In special cases they would vary less than this. 



OVERHEAD COSTS IN OTHER INDUSTRIES 


339 


These estimates do not take account of one element which is 
very inelastic over short periods, namely, the cost of materials 
used. As we have seen, investment in materials is a “sunk cost,” 
in that it cannot be unmade, if demand falls off, and if prices fall, 
the original cost cannot be easily recovered. One could try, of 
course, but the only result would be to lose more by not selling 
goods than by putting prices low enough to sell them. 

Thus it is considered wise practice, when prices of materials 
have fallen, to write the value of one’s stock on hand down to the 
new market level and then undertake to make goods at a profit 
on this new and deflated cost. The chief economic logic back of 
this may lie in the fact that the last supplies of goods, which 
govern the market, are made from materials bought at the new 
prices, by producers who would not have done it if it had not 
appeared worth their while. This is the competition which 
every producer has to meet, no matter when his materials were 
bought, and he places himself on an even footing with it, so far 
as accounting can do so, by taking his loss on his materials and 
not letting it affect his present price policy. Thus a large invest¬ 
ment in materials is even worse than a large investment in 
specialized machinery, when prices swing downward. Observa¬ 
tion indicates that at such times businesses with large commit¬ 
ments in materials are the worst sufferers, rather than those 
whose costs consist largely of charges for fixed capital. 1 

3. MERCHANDIZING 

If the manufacturer’s outlay for materials covers other 
producers’ overhead costs to an amount larger than his own, still 
more is this true of the merchant. The studies of the Harvard 
Bureau of Business Research show the cost of goods sold to have 
averaged, for recent years, 62.7 per cent of net sales in retail 
jewelry stores, 68.1 per cent in retail shoe stores, and 88.1 per 
cent in wholesale grocery establishments. 2 If a commodity 

1 This point is made in an article by Alvin H. Hansen on“ Prime Costs in the 
Business Cycle,” Journal of Political Economy , XXXII, 11-13. 

8 See C. E. Frazer, “The Readjustment of Retail and Wholesale Operating 
Expenses,” Harvard Business Review (January, 1923), pp. 222-24. The figures 
for jewelry cover 1919-21; for shoes, 1918-21; for department stores, 1920-21; 
and for the wholesale grocery trade, 1916-21. 


340 


ECONOMICS OF OVERHEAD COSTS 


retails for one dollar, the retailer may typically keep twenty- 
eight cents out of which to pay all his expenses, the wholesaler 
twelve cents, leaving sixty cents as the cost of the goods them¬ 
selves, of which perhaps twenty-four cents go to manufacturers, 
sixteen for all forms of transportation, divided about equally 
between railroads and other agencies, and twenty cents to 
agriculture, forestry, and mining, while government may con¬ 
tribute one-half cent or more as free overhead, chiefly in interest, 
depreciation, and maintenance on streets and highways. The 
strictly constant capital costs—interest, taxes, and insurance— 
may absorb seven cents in retailing, three cents in wholesaling, 
three and one-half in manufacturing, nearly four cents in transpor¬ 
tation, and about five cents in agriculture, forestry, and mining. 

Thus the money the retailer pays for his goods goes to cover 
other people’s overhead costs totaling twice as much as the 
retailer’s, and the money the wholesaler pays for goods covers 
overhead outlays four times as great as those of the wholesaler 
himself. Evidently, while it is important for the merchant to 
protect his own overhead, it is more important for industry as a 
whole that his part in the system of production should be so 
ordered as to help protect the overhead of the producers from 
whom he buys. This means less retrenchment on the part of 
dealers when demand falls off and prices sag, but it can only 
be made possible by refraining from overstocking when business 
is active and prices are high and going higher. The questions 
this raises are not simple, but it is clear that if a more stable 
control of buying could be brought about, it would be a great 
gain to the dealers themselves. But that is another story, and 
must wait until we come to the question of the business cycle. 

How elastic are the expenses of mercantile establishments in 
response to changes in volume of business ? The available figures 
go to show that expenses vary far less than sales, but this evidence 
is useless for purposes of quantitative estimates, since the volume 
of sales measures the ups and downs of prices far more than of 
physical output. Expenses may be reduced by cutting wages 
or by reducing the operating and selling force. Cutting wages 
is a doubtful benefit, for the best employees tend to go over to 


OVERHEAD COSTS IN OTHER INDUSTRIES 


341 


competitors who have maintained wages, and the concern may 
lose more, in the long run, than it gains. Reductions in working 
force cannot easily be made when the concern is struggling to 
maintain its physical output in the face of a falling market. The 
policy of maintaining steady employment for the regular force 
also acts to deter employers from laying off large numbers of 
operatives. Thus there is considerable resistance to economizing 
in operating expenses. Mr. C. E. Frazer finds that mercantile 
expenses tend to rise in times of activity, and fail to subside in 
times of depression. 1 Further evidence is found in the fact that 
employment fluctuates far less in merchandising than in mining, 
transport, or manufacturing. 2 Altogether it is fair to conclude, 
contrary to the general impression, that expenses are less elastic 
in merchandising than in manufacturing, and that constant 
expenses are larger. 

So far as “cost of goods sold” is concerned, the question 
whether this is elastic or not depends on the accounting policy 
followed. If the concern charges goods at their original cost, 
this item becomes thoroughly inelastic until existing stocks are 
disposed of. And if one wishes to know the effect of business 
changes on the total profits and losses of the concern, this gives 
a true account. For purposes of guiding sales policy, it may be 
wise to write the value of goods on hand up or down, following 
the market; but this merely means that profits and losses due 
to selling goods are separated from profits and losses due to hold¬ 
ing them in stock, and does not affect the sum total. Where con¬ 
cerns have contracted ahead for goods at a fixed price, the result 
is the same, if the contracts are carried out to the letter; but 
merchants do not buy their goods in this way to the same extent 
as manufacturers. If new goods are being bought and disposed 
of along with the old, expenses become to that extent elastic. 
But this factor has least effect at precisely the most critical 
times—those when depression is setting in—since at such times 

1 See his summary of results of studies by the Harvard Bureau of Business 
research, in the Harvard Business Review , as cited in the preceding footnote. 

2 See W. I. King, Employment, Hours and Earnings in Prosperity and Depres¬ 
sion, especially pp. 4Q-52. National Bureau of Economic Research, 1923. 


342 


ECONOMICS OF OVERHEAD COSTS 


new purchases are at a minimum, and the old goods must be 
disposed of before new ones can find an unhindered market. 

This matter of the cost of goods on hand is a more serious 
disturbing element, in the short run, than the constant costs 
represented by the permanent investment, since the depreciation 
of the stock can easily wipe out the entire return to capital, and 
no retrenchment can affect the loss on goods already bought. 
On the other hand, when demand does revive, it only requires a 
small percentage of addition to the price of the product to bring 
in twofold returns on investment, so that the fat months can 
make up for the lean. Thus businesses of this class are likely 
to alternate between high returns on investment and none at all, 
and their chief problem is to bridge the chasms and achieve 
reasonable financial stability through the succeeding phases of 
the business cycle. The evil of chronic cut-throat competition 
does not affect them seriously. 

On the other hand, seasonal changes of demand are not 
marked by the same unexpected and general changes of prices 
which accompany the business cycle. True, goods go out of 
season, and have to be marked down, often without very much 
regard to their original cost; but this does not usually affect the 
whole of a merchant’s stock at once. Goods may be sacrificed, 
but it is to make room for other goods which are in season and 
will sell more rapidly. Thus it is possible to disregard the 
original cost of such remnants in order to dispose of them, and 
consider only how to realize the largest salvage, whether by 
holding the goods until another season, when they will usually 
be at a discount as last season’s goods, or by forcing them on the 
market at an even greater discount, and thus saving storage, 
with the costs of moving into storage and out again, and incidental 
deterioration. In any case the mark-down is limited to the 
remnants, and does not embrace the whole volume of sales. 

Aside from this question of seasonal obsolescence of stock, 
some seasons are duller than others, and special efforts or conces¬ 
sions may be useful in stimulating off-season demand. But since 
the idle overhead of the mercantile establishment is relatively 
small compared to the direct cost of the goods sold, the room for 



OVERHEAD COSTS IN OTHER INDUSTRIES 


343 


such concessions is more limited than in the case of manu¬ 
facturers and very much more so than in the case of public 
utilities. Special selling efforts may utilize the idle overhead 
of the selling force itself, but heavy slashing of prices is hardly 
a profitable policy. 

The economies of size appear in merchandising, though 
differences in grade of goods sold often make them hard to trace. 
In general, the large store spends a smaller percentage of its 
gross income for the goods it sells, but a larger percentage on 
operating expenses, especially advertising, while large stores 
turn their stock over more rapidly, and sell more goods per 
full-time sales person. 1 Branch houses distributing packing¬ 
house products show marked economy with increased size. 

To sum up, costs of mercantile establishments are very 
flexible if moderate time is granted, much more so than manu¬ 
facturing costs. But they are decidedly inelastic over short 
periods. The cost of goods sold is a direct cost of output, but the 
actual amount spent quickly becomes a matter of ancient 
history: a “sunk cost.” If the present differential cost of 
getting more goods is more than the amount actually spent for 
the stock on hand, well and good; if less, then sales may show a 
profit above differential cost, and the concern may still go 
bankrupt. 

4. AGRICULTURE 

As has already been suggested, the most definite indivisible 
unit in farming consists of the farmer himself and his family. 
Outside help is used to tide over the peak demand of planting 
time and harvesting time, but it is characteristically hard to get, 
largely on account of this very irregularity. Land and improve¬ 
ments, buildings, farm implements and machinery and work- 
animals constitute a fixed investment with an unusually long 
average life. The total area of potential agricultural land in 
the world is, in a sense, absolutely fixed; and where it needs 
clearing, drainage, or other reclamation work it cannot be made 

» See Frazer, op. cit ., pp. 219-20. Also Survey of Retail Distribution of Clothing 
V, 15, 187, 277, 395, 406, 420, and elsewhere. Northwestern University School of 
Commerce, Bureau of Business Research, Horace Secrist, director, 1921. 


344 


ECONOMICS OF OVERHEAD COSTS 


quickly available in large amounts. However, there is far more 
elasticity in the amount actually put under the plow and culti¬ 
vated to the major crops, and still more where any one crop is 
considered. The chief resistance to such adjustments is personal, 
depending upon the knowledge and adaptability of the farmer 
himself. Men do what they know how to do rather than incur 
the risks and wastes of trying to find some theoretical “best 
combination” of crops and methods. Farming is one of the most 
difficult of trades, and the knowledge unconsciously picked up 
from childhood on, and habits unconsciously formed, constitute 
a personal capital whose value is very great and whose inertia 
is hard to overcome. This inertia has to be broken up and this 
personal capital converted into something more mobile, through 
widespread education, not merely in scientific methods but in the 
methods of picking up and utilizing new scientific methods as they 
come within reach, before this form of agricultural capital can 
be made as mobile as the good of the agricultural community 
requires. 

The single farm has a land area which is often taken for 
granted as a constant factor, and it is not always convenient 
to change it. Nevertheless many farm owners rent additional 
land—14 per cent of one group cited by Nourse. 1 All in all, the 
total fixed investment in farms is large—far larger in proportion 
to output than in any major class of industries except railroads 
and public utilities. It has been estimated that rent of land 
alone accounts for one-fourth the cost of raising potatoes in 
Maine, under intensive cultivation, and one-third in Wisconsin, 
under extensive cultivation. 2 Two groups of farms of varied 
character show receipts a trifle over 20 per cent of capital. An 
inspection of some budgets shows about one-fourth of the total 
expenses to be of a character indicating that they are probably 
constant to about the same degree as the return on capital 
invested in railways. 

Thus farming is like railroading in that a wide margin above 
“out-of-pocket expenses” is required to cover return on invest- 

1 See E. G. Nourse, Agricultural Economics, p. 285. 

9 Ibid., pp. 452 - 53 - 


OVERHEAD COSTS IN OTHER INDUSTRIES 


345 


ment and to provide for betterments, if these are to be made out 
of income. Accordingly the return can fall far below the eco¬ 
nomically necessary yield on investment and still cover the actual 
out-of-pocket expenses, so that the industry may drag along 
chronically in a half-starved condition without reaching an 
absolute limit. In other words, it clearly has the characteristics 
which invite “cut-throat competition,” aggravated by the 
inertia of the human capital involved. This in turn is made 
worse by the small-scale character of the business, which makes 
it a burden to keep accurate cost accounts, while special cost 
analyses must be made by government or some other agency com¬ 
manding large funds, if they are to be made at all. 

A further difficulty arises from the length of the season and 
the uncertainty of the yield. Few manufacturers would start 
to make goods for as many months ahead as the farmer does, 
without a contract at a definite price for a definite quantity 
which he knew he could turn out. The “sunk cost” involved 
would be too great. But the farmer has no choice; he must incur 
it if he is to produce at alk Broadly speaking, there are two 
points at which he controls his output. One is at planting time 
when he decides what he will try to produce, subject to the 
chances of the season, insect enemies, and other uncertainties. 
His chance of a yield must appear to him worth the sacrifice he 
incurs for it, but in estimating this differential sacrifice, his 
mortgage is a constant item, and in most cases the greater part 
of his investment behaves as a constant cost. The other point 
where output is under control is at harvesting time, when he is 
free to let the crop rot if it will not cover the cost of gathering 
and shipping it. By this time, all his other expenses are sunk 
costs, and he must simply recover what yield the market permits. 
Add to this the fact that at planting time, when control of output 
must be exercised if it is to have any effect, all the growers are 
committing themselves at about the same time, so that there is 
little chance for each one to govern his policy by a really accurate 
knowledge of what the others are doing. If manufacturers 
were ever so rash as to make “to stock” goods which required 
a whole season to finish, they would not start them all at the 


346 


ECONOMICS OF OVERHEAD COSTS 


same time of year, and if their rivals’ output threatened to glut 
the market, each one could, if he saw fit, curtail his own schedule 
of production at any time. All in all, the co-ordination of supply 
and demand faces peculiar difficulties in agriculture and the 
producer’s legitimate means of protecting his overhead sacrifices 
operate under enormous handicaps. 

Aside from the problems of adjusting supply to demand, there 
are problems of internal organization. Farm work is very 
irregular, in ways which have nothing to do with irregularity 
in demand for the products. Farm machinery, work animals, 
and hands, all have very poor load factors. The work of horses 
tends to concentrate in two or three months, and specialized 
machinery has an even shorter term of use. Gang plows, 
seeders, and other improvements can make striking savings in 
the time required for plowing and planting, but they must do at 
least a fair amount of work to be economically available. 1 Some 
of these difficulties can be overcome by co-operative ownership 
of machinery, though the difficulties inherent in this system make 
large farming units a far simpler solution., 

Indeed, so far as physical units are concerned, the farm shows 
many chances for the economies of size. A large barn costs less 
per unit of contents than a small one, just as a large boiler does; 
and farms of large acreage can be adequately equipped with 
buildings, horses, and machinery at less expense per acre than 
small farms. 2 Under the system of accounting used in agricul¬ 
tural investigations, the profit-and-loss account is merged with 
the labor income of the farm owner who works on his own 
farm. This residual share increases with the total capital 
invested in the farm, and increases progressively, though with 
curious irregularities. 3 These may be partly the result of 
groups of farmers who have too much land and not enough 
working capital, and “gentleman farmers” who build model 
barns costing so much that the overhead far exceeds the possible 
yield of the cattle they will house. Apparently where conditions 

* See Nourse, op. cit., p. 272. 2 Nourse, op. cit., p. 285-86. 

3 United Stales Department of Agriculture , Bulletin No. 41 , pp. 11-13. Reprinted 
by Nourse, op. cit., p. 275. 


OVERHEAD COSTS IN OTHER INDUSTRIES 


347 


permit the adequate utilization of expensive equipment, large- 
scale farming pays, though an investment of $10,000 to $15,000 
shows the highest labor income per dollar of invested capital. 
The reason why farming is not a large-scale industry is largely 
to be found in the difficulty of supervising the personnel, though 
partly also in the character of the ground, which often makes 
expensive machinery difficult to operate. 

From this brief sketch we can see that agriculture presents 
the typical problems of overhead cost, often in very intense form. 
In particular, it is an industry peculiarly subject to what is really 
a form of cut-throat competition. Add to this the difficulties 
of marketing and the fact that the typical farm has too little 
working capital for its land area and has not the type of security 
which easily secures capital on favorable terms, and there is 
more than adequate reason for a great movement toward agri¬ 
cultural combination and co-operation, such as we are at present 
witnessing. Add to this the fact that farming, being a small- 
scale industry, is peculiarly dependent on public or co-operative 
research to maintain and improve the “ state of the art,” and to 
furnish quick and reliable information as to acreage planted 
and other vital matters, and one cannot fail to conclude that 
agriculture is a business “ affected with a public interest” to a 
very large extent indeed. 

5. COAL MINING 

Bituminous coal mining has been much before the public 
of late in ways which make it a well-nigh intolerable public 
nuisance. Outside of the recognized public utilities, it is the 
only great industry in which a seasonal cycle has been universally 
recognized as a public evil, and proposals made and action taken 
looking to its cure; and the only industry in which an oversupply 
of productive capacity has been stated in official reports as a 
fact injurious to the public and official action has been taken to 
restrict the evil. “Idle overhead” is one of the largest features 
of the soft coal problem. 

Soft coal mining is a business of some 7,000 operators, few of 
whom are large, and none of whom dominates the market, except 


348 


ECONOMICS OF OVERHEAD COSTS 


locally. Bituminous coal is so widely distributed that there is an 
indefinite number of possible competitors, able to produce at a 
profit when prices reach their peak. Most of these are classed 
as “wagon mines,” not having a private railroad spur. The 
preliminary report of the present Coal Commission states that 
only 60 per cent of the mines in existence would be sufficient for 
the needs of the country, and the Interstate Commerce Commis¬ 
sion has recently refused the Virginian Railway authority to 
construct an extension to a mine, stating in its report on the 
case that there are more mines than is consistent with efficient 
use of the carriers’ equipment and that fewer mines could 
produce more coal, because the railroads 5 car supply could be 
handled to better advantage. 1 

The output of coal is limited, not by mines but by freight 
cars, because coal is dumped direct from mine car to freight car, 
saving an extra handling and the cost of storage at the mine. 
This feature of the industry does not seem to be seriously ques¬ 
tioned, since it would do no good to regularize mining without 
also regularizing the transportation of the coal, and if transporta¬ 
tion is to be regularized, coal must be stored, not at the mine, 
but near the point of consumption. This makes it technically 
possible to keep both mines and coal cars working with complete 
regularity, but apparently it is not commercially possible as 
things are now. Coal mining is seasonal, and would be more so 
if the peak were not checked by the shortage of cars. As it is, 
mines sometimes seem to lose almost as much time in the busy 
season as during the rest of the year. 

Mines typically operate from 190 to 230 or 240 days in the 
year, or an average of perhaps 215 days out of a possible 308. 
The miner, however, does not work as many days as the mine— 
in one group of reported cases miners averaged 117 days. 2 The 
explanation and blame, if any, for this discrepancy is a matter 
of dispute, but whatever may be the answer, it appears that the 
load factor of the miner is a more serious question than that of the 

1 See Railway Age, LXXIV (June 30, 1923), 1691. 

a Average of 41 Illinois mines in 1920. Reported by Illinois Coal Operators’ 
Association. 



OVERHEAD COSTS IN OTHER INDUSTRIES 


349 


mine. The answer might even be that no man ought to work 
more than 117 days underground, but that they ought to piece 
out their mining with gardening or some other work which would 
partly support them. If some conclusion on this whole matter 
could be definitely reached, it would clarify the basis of wage 
adjustments. 

In order to regularize mining, the mines must produce some 
coal to be stored from the spring until the following winter. 
It only pays to do this with coal whose present value, or cost, 
is less than its future value by enough to pay the costs of storage; 
and at present it does not seem to be thought profitable to store 
enough coal to bring about full regularization. But there is 
reason to doubt whether this answer can be taken as final. 
In figuring the minimum price it pays to accept for the sake of 
keeping the mine running in the off season, the operator pre¬ 
sumably charges nothing for return on his investment or other 
overhead expenses which run on whether the workings are open 
or not. But he does figure the wages of the labor that takes out 
the coal as an expense which must be covered. This is so 
obvious that it seems insane to question it, yet there is strong 
ground for the thesis that this is not sound cost accounting from 
the point of view of national efficiency or even from the point 
of view of the mine operators themselves in the long run; and 
that wages, in the long run, are nearly as much an overhead 
cost as interest on investment is, for purposes of figuring the 
economy resulting from keeping the workings going in slack 
times and utilizing to the full the productive capacity of the 
industry. 

In the long run it is probably yearly earnings, rather than 
rates of wages per ton or per day, that have to be maintained at 
a level high enough to attract labor in competition with other 
occupations. This assumes that wages are fixed with reference 
to coal miners who have no side occupations which can be 
dovetailed with coal mining and so contribute substantially to 
meet the cost of living. Wage-rates in the anthracite fields are 
now lower than in bituminous production, partly because 
anthracite mining is more regular. If yearly earnings from min- 


35o 


ECONOMICS OF OVERHEAD COSTS 


ing are the significant thing, the operators have to pay very nearly 
as much wages for 215 days’ work in a year, or 117 days, as they 
would have had to pay for 250 days or 300 days, if they habitually 
operated that many days. But this is not quite the same thing 
as saying that they could now increase the year’s work to 250 
or 300 days without materially increasing yearly wages. This 
might be true, but only in such a very long run that no one could 
ever tell for certain whether it were true or not. And in the 
short run, the private operator is quite correct in figuring that 
if he works ten extra days in the off season his wage bill goes up 
by exactly ten days’ wages. For this reason it is sometimes 
proposed that labor should be employed on a yearly contract, 
so that wages would become just as much an overhead cost as 
capital—and just as much an overhead cost to the employer 
as labor is to the nation at large. Whether this is practicable 
or not, it embodies a sound principle. 

For the nation as a whole, its labor power is a fixed asset 
and any failure to utilize it is just as definite a loss as failure 
to utilize a mechanical plant. It pays, socially, to utilize labor 
so long as it produces anything toward its own necessary upkeep, 
which must be met somehow in the long run. Thus social 
cost-accounting shows a gain from employing labor in a slack 
season, even if the product will not pay regular day wages to 
the laborers: social accounting shows a gain where private 
accounting would show a loss. It is in the light of this sort of 
accounting, with labor largely an overhead cost, that those 
interested in the industry should study the costs of storage and 
other ways and means of regularizing production. 

But is there any way of getting private producers to adopt 
findings that are in conflict with ordinary cost-accounting? 
The question hinges on whether it is possible to make wages, 
within limits, virtually an overhead cost to the employer. 
Anything which would accomplish this result would put the 
regularizing of coal production on a sound economic basis. 
We might exhort the wage-earners to work for less pay in the 
spring and summer months, but this hardly offers an inspiring 
prospect of success. A more tangible proposal would be a 


OVERHEAD COSTS IN OTHER INDUSTRIES 


351 


sliding scale of wages, in which the wages per day or per ton are 
reduced as the number of days’ operation is increased, in such 
fashion as to give the wage-earner some increase in yearly 
earnings and the employer a decided reduction in the wages 
cost of coal per ton. It would need to be a decided reduction, 
because if the plan succeeded there would be more coal to be 
marketed and the price would presumably have to come down. 

It is not easy to draw up specifications for embodying this 
sliding-scale principle in a wage rate. The most practicable 
method may possibly be to set a goal of so many days’ operation 
within a certain period, and a basic rate of wages figured on the 
assumption that this number of days’ operation is actually 
attained. If the goal is not reached, the employer should pay 
a bonus wage for the time actually worked, the bonus to be figured 
on the sliding-scale principle, so that the men do not get quite 
as high total earnings with the bonus as they would without it 
if the goal of operation had been reached. If the goal is exceeded, 
possibly the contract could provide a sharp reduction in wages 
for the remaining days of the period. This might not, however, 
be practicable. Probably a better way would be to give the 
employer some latitude in setting the goal, his basic wage rate 
varying with the number of days’ operation that is taken as the 
objective, according to the sliding-scale already worked out. In 
this case it would be to the employer’s interest to set the goal high, 
and it might become necessary to set a maximum limit on the 
output goal and a corresponding minimum limit on the basic 
rate of wages. The wage-scale should be so fixed as to provide 
fair minimum earnings if production is not speeded up, while 
the gain from increasing the number of days’ operation should 
go more to the employer than to the employee, in order to defray 
the costs involved in regularizing production. The length of the 
period taken as a unit for calculation would also need to be very 
carefully considered. 

The above is only one suggestion of a means to the desired 
end. If the matter were given serious thought, other and 
better plans would doubtless be devised, though none would be 
“fool-proof,” nor free from administrative difficulties and the 


352 


ECONOMICS OF OVERHEAD COSTS 


need of guarding against evasions. But some system of payment 
working on this principle would give a substantial incentive to 
regularize this wasteful industry. Seasonal freight rates might 
contribute to this general result, though by themselves they 
would be of little effect. 

Of course, if the cost of storing bituminous coal is absolutely 
prohibitive, and conversion into coke impossible, all this is 
useless talk. But a cost that would be prohibitive to private 
operators on the ordinary basis of figuring may be far from 
prohibitive if the problem is attacked in the light of the commu¬ 
nity method of reckoning overhead costs. 

Apart from this, there seems to be much room for increasing 
the general efficiency of soft-coal mining through the application 
of known technical principles. Soft-coal mining is a decentralized 
industry, and the mine foreman is not commonly a technically 
trained engineer, nor in touch with the best methods in use in 
other mines. The community’s intellectual capital is not being 
fully utilized: there is “ idle overhead” here, real if imponderable. 1 
The most revolutionary proposal is to concentrate the burning 
of coal near the mines in vast central power plants, trans¬ 
mitting it by electricity. This would reduce the manufacturer’s 
overhead, shifting his power cost to an industry of the type 
which has the most scientific methods of stimulating regular 
use. The railroads would still have the most irregular part of 
the coal demand to handle: that for heating purposes. 

6 . OVERHEAD COSTS IN PUBLIC SERVICES 

It is a commonplace that the costs of government depart¬ 
ments are not reported on a basis comparable with the standards 
of good accounting found in private business. In particular 
not only are interest and depreciation on investment neglected, 
but the investment itself is commonly ignored and the line 
between capital and current outlays is frequently blurred. 

1 See paper and discussion by A. J. Mason and others, American Economic 
Review Supplement (March, 1921). The recent survey by the “Hoover Committee” 
entitled “Waste in Industry” contains much testimony of waste due to failure to 
make general use of available knowledge. 


OVERHEAD COSTS IN OTHER INDUSTRIES 


353 


This is not the place to undertake a resurvey of public budgets, 
but a few matters of general principle may be touched upon. 

Should interest on permanent investment be charged as a 
cost of government operations? The practical exigencies of 
private accounting do not affect the government. It does not 
declare dividends, nor require to show a commercial balance 
sheet in order to borrow money from banks. And if it sells goods 
it is free from the compulsions of competition: it can follow any 
policy which may appear wise, and can fix any relation it pleases 
between the price and the total economic sacrifice involved in 
rendering the service. In a word, its problems are those of cost¬ 
accounting and analysis rather than of financial accounting, 
and as we have already seen, for cost-accounting purposes interest 
is an important item to consider. On the other hand, where 
essential public buildings are constructed out of taxes without a 
thought of money return, interest is not a part of the necessary 
supply price of the service, and there would be no point in charg¬ 
ing it. Nevertheless, a real issue does arise as to the extension 
of public services, especially into those optional services of an 
economic character. This involves capital as well as current out¬ 
lays and fair comparison cannot be made if capital is ignored. 
The efficient apportionment of capital requires some accounting 
charge for its use, whether it is raised by bonds or by taxes, or 
leased from private owners. Where it is a question whether 
to lease or to build, interest on the cost of building is a decisive 
item. 

How much does public capital really cost the country at 
large? The traditional economist’s view is that the country 
has just so much income, and that an increase in public capital 
means just that much taken from private productive investment, 
or from funds which would otherwise go for consumption. 
This is true in a very general way, but only in a very general 
way. It ignores the fact that the national product and national 
income are elastic and that, under certain conditions and within 
limits, an expenditure may come at least in part out of an increase 
in the national product, through stimulating the industrial organ¬ 
ism to exert some of its temporarily unused capacities. Thus it 


354 


ECONOMICS OF OVERHEAD COSTS 


is by no means self-evident that every outlay of public funds 
brings about an equivalent sacrifice of private investment or 
private consumption. On the contrary, under special conditions 
a public expenditure may be virtually costless to the community, 
for example, public works used as means of preventing unem¬ 
ployment. But depreciation is always a cost and should be 
reckoned with, and the amount of the investment should be 
known, whether interest is charged on it or not. Furthermore, 
where the public is rendering a service which might be rendered 
by a private company, the accounts should be kept and made 
public on precisely the same basis as those of a railroad or a 
gas or electric utility. 

7. OVERHEAD COSTS IN “CONSUMPTION” 

The sharp separation which is drawn in economics between 
production and consumption tends to obscure some very impor¬ 
tant facts. For many of the operations of “consumption” 
are identical in their physical and human character with many of 
the operations of production. A private residence may change 
into a boarding-house with only secondary changes in the 
character of the brainwork and handwork involved in administer¬ 
ing it, or in the character of the budget which would be needed 
to set forth its economic status. Buying is a profession and the 
selection and use of household materials is an art verging on 
applied science; between them they are capable of absorbing more 
time than most full-time industrial occupations, and both are 
work, not play. True, the industrial revolution has taken the old 
household industries out of the home, and, of what is left, a 
great deal is cared for in spare moments which are not thought 
of as possessing economic value or involving economic cost. 
They are a sort of human overhead outlay. Modern hotel and 
apartment living is doing its best to reduce this remainder to the 
vanishing-point, but it has not yet wholly succeeded. 

The fixed investment in a dwelling-house is a constant and 
more or less specialized outlay. It can shelter a larger family 
without corresponding increase in cost: and it is hard to adapt 
to changed conditions in the character of the demand—witness 


OVERHEAD COSTS IN OTHER INDUSTRIES 


355 


many residence districts full of misfits and anachronisms. The 
growth of apartments testifies to the economies of size, and central 
heating plants contain possible savings of combination. 

The work of the household—buying, cooking, planning meals, 
etc., is largely an overhead cost. 1 Here the economy of a large 
family is very real, though it is so narrowly limited and so 
bound up with other and more important qualitative values that 
a serious economic discussion of it might seem to argue lack of a 
sense of humor. It is of substantial importance, however, in 
the present-day attempts to produce a scientific measure of the 
minimum needs of families of different sizes. More complex 
are the possibilities of combination and co-operation. Indeed, 
one of our distinctive modern tasks is to bring into being a fund 
of really scientific information on these matters and to mobilize 
it for the service of the private household, thus giving the 
household manager the benefit of what would be a prohibitive 
overhead outlay if it had to be financed by every family for itself. 

8. CONCLUSION 

Fragmentary as the foregoing survey is, it should serve to 
indicate that every branch of economic activity has problems 
of overhead cost, now in one form and now in another but always 
of real importance. They are not confined to any one type of 
industry. We have been taught to look for overhead costs in 
businesses employing large amounts of fixed capital. These are 
usually large businesses whose size is sufficient proof that the 
economies of large-scale production are at work. But farming 
shows large fixed investments and small-scale operation, and 
where both these characteristics are lacking, others equally 
potent appear. If the stock of materials is large, they constitute 
a sunk cost in times of falling prices. If neither fixed nor circulat¬ 
ing capital is large, labor will present some problems of overhead 
cost. And if the business is organized in small units, that 
very fact creates a special problem in organizing the intellectual 

1 Some of these possibilities are briefly suggested in a monograph: “What Can 
a Man Afford?” by Paul and Dorothy Douglas, American Economic Review 
Supplement No. 2 , (December, 1921), esp. p. 64. 


356 


ECONOMICS OF OVERHEAD COSTS 


overhead—the “state of the art” and the industrial and com¬ 
mercial knowledge requisite to effective operation. 

Of all these aspects of overhead cost, the least familiar and 
least appreciated is the human side of overhead costs, their 
importance in the human economy on which the financial 
economy rests, and the relation of overhead costs to labor in 
general. Without some apprehension of the underlying human 
facts, one cannot see in true perspective such objective financial 
phenomena as the business cycle or cut-throat competition. 
Therefore, we shall next turn to the subject of overhead costs 
and labor. 


CHAPTER XVIII 

LABOR AS AN OVERHEAD COST 

SUMMARY 

The human machine: its dual character, 357—The “fatigue of the marginal 
hour,” 359—Ultimate costs of labor analyzed, 361—How much unemployment is 
necessary, 366—Cost of labor to the employer, 370—The burden of unemployment, 
372—Methods of diminishing the burden, 376—Conclusion, 384. 

I. THE HUMAN MACHINE: ITS DUAL CHARACTER 

The human body is a mechanism and something more. We 
are gradually enlarging our knowledge of it in its capacity as 
mechanism, and the results have profoundly altered our ideas 
of the human costs of industry. A man “feels tired.” Muscular 
exertion becomes unpleasant; the attention flags and wanders. 
Beyond this stage there may come a “second wind,” or even a 
third or fourth, though there is an ultimate limit at which the 
muscles protest in positive pain and fail to respond to stimulus. 
If the will whips the body too unsparingly and for too long a time, 
there may come a deeper inner fatigue which seems to sap the 
sources of effort so that one feels enfeebled rather than tired. 
All these sensations are symptoms of things which are happening 
to the bodily machine, but the symptoms are none too reliable 
and none too easy to interpret. Cells are destroyed and must 
be replaced; poisons accumulate and must be eliminated and 
there may be positive injury, attrition, or malformation of 
particular parts of the body, not to mention tne recognized 
occupational diseases and infections. 

And all the while this human engine remains a conscious 
being; it must be reached through conscious stimuli to develop 
the output of energy for which it was designed, and the serious¬ 
ness of all this material wear and tear is at bottom almost wholly 
a matter of what the conscious being thinks and feels about it. 
One would say “wholly,” but for the fact that some of the 
ultimate values appear to be unconscious; the conscious mind 


357 



358 


ECONOMICS OF OVERHEAD COSTS 


decides on one thing and the man does another. The chief 
difficulty is that when a person is doing the things which damage 
his health, he does not know how it is going to feel to go on 
living and working with impaired vitality. And by the time he 
does know, it is too late to undo what he has done. The sense 
of fatigue undoubtedly came into being because it was a valuable 
safeguard against overstrain, and it seems to work fairly well 
with respect to the kinds of strain known to primitive man. 
But the new strains of our machine shops and offices are a different 
matter, and against them the untaught sensations of the human 
organism are not such trustworthy guides and protectors. 

From the physiological standpoint, the critical point is 
whether the poisons of fatigue are carried away during periods 
of rest and the destruction of tissue made good. Beyond this 
point, fatigue is cumulative and the organism suffers; short of 
this point fatigue would not be reckoned as a cost at all, but 
rather a physiological benefit. In a general way, the feelings of 
the average well-energized person agree with this standard, but he 
cannot be trusted to know when he crosses the line, especially 
in our modern sophisticated forms of work and play. This is 
especially true as a human being has a very large “ overload 
capacity”; he can stand enormous strains for a limited time if 
he has a chance to recuperate, and he works his best when the 
pace and strain vary, not on a monotonous dead level of moderate 
exertion. He also works his best when he gets a reasonable 
variety; and a job in which the worker can find no variety at all 
is well-nigh intolerable, as well as likely to overexert some parts 
of him, leave others underdeveloped, and subject others to 
unnatural stresses which may produce injuries in the end. 

Another fundamental fact is expressed by William James in 
his Energies of Men. A man may be living on a given allowance 
of food, sleep, and work, and maintaining his weight, strength, 
and nervous energy in equilibrium. Reduce the amount of food 
or sleep, or increase the amount of work and unless he had 
previously been actually overeating or oversleeping, his weight 
and energy will decline. But they will not decline indefinitely: 
he will reach a new equilibrium. The human engine can main- 


LABOR AS AN OVERHEAD COST 


359 


tain itself in some sort of equilibrium on widely different amounts 
of rest, nourishment, and output. Especially in the matter of 
energy, most individuals have large untapped reserves and are 
capable of being far more thoroughly energized. Even the 
physiological ratio between attrition and recuperation is probably 
much affected by one’s state of mind, and the limits of monoto¬ 
nous toil, even in a physiological sense, are undoubtedly made 
narrower because the work is not of a character to do justice to 
the latent powers of the individual nor tap his reserves of energy. 
Given the quality of the work, however, physiological limits are 
fairly definite. The questions we shall deal with have mostly 
to do with failure to utilize the powers which these ordinary 
physiological limits make possible and the energies which the 
common incentives of industry are capable of calling forth. 

2. THE “FATIGUE OF THE MARGINAL HOUR” 

The usual analysis of the human cost of labor explains that, 
while work may be a positive pleasure when one is fresh, it 
becomes more and more fatiguing until the ever increasing 
fatigue outweighs the ever decreasing worth of more pay, and 
the man stops working. So far as this analysis goes, the human 
cost of labor would be wholly a variable cost. This analysis 
has some truth as a partial explanation of forces governing the 
length of the working day, but it is hardly relevant at all to the 
other questions which hinge on the ultimate cost of labor, and 
it leaves out so much that it appears to be little more than one 
stone in an unfinished edifice. 

From the physiological point of view, fatigue does not begin 
to be a cost until it involves attrition which the day’s rest and 
food will not make good, and beyond this point the cost suddenly 
becomes prohibitive in the sense that virtually no reward is 
worth earning at the price of positive injury to the person himself. 
Thus instead of being governed by a nice balancing of efforts and 
rewards, the physiological working-day is governed almost 
without regard to rewards. Almost, but not quite, for higher 
rewards mean better food and living conditions and this raises 
the physiological maximum, and at the same time makes it less 


360 


ECONOMICS OF OVERHEAD COSTS 


compulsory upon the worker to work up to his limit. It is 
only the lowest rewards that justify working beyond the point 
where injury to the organism begins. In other words only the 
utter necessities of present existence are important enough to 
justify overworking in the struggle to secure them, to the point 
of sacrificing the fundamental necessity of a healthy constitution. 

Aside from utter destitution, it is not so much fatigue which 
sets the desirable length of a working-day as the need and craving 
to spend energy in other ways, and to seek relaxation and recrea¬ 
tion. It is the urgency of competing calls upon one’s energy and 
time. The most important aspect of the human cost of labor 
is the aspect of alternative cost. Otherwise it would be hard 
to explain why the employees of one self-governing establishment 
were better satisfied with a five-day week of nine hours a day 
than with five eight-hour days and four hours on Saturday . 1 
Another interesting practical consideration is that when the 
length of the working-day is under discussion between an 
employer and organized labor, the discussion seldom takes the 
form of a choice of shorter hours and correspondingly less pay, 
but rather of a demand for a concession in hours without sacrifice 
of wages. The free individual choice appears when a workman 
chooses between different jobs, such as twelve-hour and ten-hour 
shifts in a steel plant. 

But most of the variations in work have nothing to do with 
a voluntary choice of a longer or shorter work-day. Work stops 
on account of weather, lack of materials or lack of orders, and 
men are put on part time, laid off, or discharged. Here is a 
clear loss of work which is worth far more than it costs the 
worker, for its cost to him is little or nothing unless he is unusually 
fortunate in possessing available side occupations. If he has 
to look for a new job, this in itself costs him more, humanly 
speaking, than the doing of a reasonable day’s work. Thus we 
arrive at the fundamental proposition that as a general thing, 
with respect to involuntary idleness, the differential cost of 
labor is negligible. When labor is laid off, no material human 
cost is avoided, and if work is found to fill up the gaps, human 

X W. P. Hapgood, Survey (September i, 1922), p. 656. 


LABOR AS AN OVERHEAD COST 


361 


costs do not increase in proportion to work done. If we are to 
think of labor as involving human costs, we must think of them 
as overhead costs, for they certainly do not vary with output 
in this large and vitally important class of cases. 

3 . ULTIMATE COSTS OF LABOR ANALYZED 

The cost of labor may be viewed from at least five stand¬ 
points: fatigue of labor, maintenance of the laborer, return on 
investment in labor power, alternatives open to the laborer, 
and finally the money cost of labor to the employer. Fatigue, 
as we have already seen, is not such an elastic thing as people 
ordinarily suppose, especially from the long-run physiological 
view. Nature says: “Here is a given capacity for enduring 
fatigue. Use it freely; you will be better and happier if you 
do; but do not overstep its limits.” If these words were used 
of a machine, we should conclude that the cost of using that 
machine was largely a constant cost. Labor is sufficiently 
similar to justify the same conclusion. 

The necessary maintenance of labor is even more clearly an 
overhead cost. Hard physical work calls for more food and the 
higher grades of mental and directive work require leisure for 
reading, travel, and other forms of productive consumption. But 
underneath is a constant element: the minimum standard of 
living. 

What is the nature of this minimum? It takes two forms, 
both of which have their counterparts in industrial accounting. 
One is the maintenance of the existing fund of vital power, and 
the other is a goal or standard of satisfactory maintenance. 
One corresponds to the accounting conception of maintenance 
and provision for depreciation; the other corresponds to the 
standards of performance which attempt to increase efficiency— 
standards which are always mechanically attainable but often 
very difficult to attain in view of the human equation and com¬ 
mercial conditions. The laborer cannot live forever, any more 
than the machine, but he must replace himself without evident 
deterioration of the stock. In fact, occidental civilization is so 
accustomed to something which it calls “progress,” that unless 


3 62 


ECONOMICS OF OVERHEAD COSTS 


there were at least some change which could be so construed by 
anxious observers and willing “ boosters,” most occidentals 
would feel that life was an intolerable failure, and the results 
would be serious. This has its accounting analogue in better¬ 
ments charged to operating expenses, or in reserves for contin¬ 
gencies. 

Thus the bare maintenance of the status quo merges into 
an arbitrary standard of satisfactory performance, and the 
dividing line is a hazy one. The objective of the “social mini¬ 
mum” is to prevent any considerable class from sinking or 
remaining below a given minimum. But it is coming to be 
recognized that the minimum is an elastic thing, and students 
of this question tend to distinguish three levels: the minimum 
of physical existence, the minimum of decency, and the minimum 
of comfort; and they have come to recognize that the social 
income is not sufficient to provide the higher minima for the 
poorest groups of workers, and also meet all the other unavoidable 
demands upon the funds. 

Another standard which might be set as an ideal goal is a 
level such that it costs the community less to maintain it than to 
fall below it. There are costs of institutional relief to be borne 
if maintenance is not met, and much larger losses in productive 
efficiency. Without attempting to define just where this line 
comes, we can be quite sure that the laborer does not avoid 
the cost of maintenance by sleeping on a park bench and living 
on fifteen cents a day; he deteriorates and both he and the 
community bear the cost of the deterioration. Thus there is a 
very large element of maintenance cost, or its equivalent, which 
goes on whether the laborer is employed or not, and which falls 
on the laborer if he has reserves to meet it, and on both laborer 
and community if his reserves are inadequate. 

Another element in labor calculations is the return on the 
investment which labor represents. Training is an investment, 
and the maintenance of the minimum standard is a paying 
investment for the community as a whole, but these have one 
distinctive peculiarity, since no matter who makes the invest¬ 
ment, the result is the private property of the laborer himself. 


LABOR AS AN OVERHEAD COST 


363 


Others may benefit, but they cannot own the thing from which 
the benefit arises, because they cannot own a human being. 
Some modicum of training every firm must give its workers, 
but beyond this minimum lies a wide zone of potentially profitable 
human investment. If the worker himself can afford the cost, 
well and good. But if he cannot afford it someone else can, and the 
community as a whole cannot afford to allow it to be neglected. 
If capitalists invest funds in training others, the yield may be a 
high one, but there is no way by which the capitalist can appro¬ 
priate it. He must in most cases advance the money without 
tangible security, and such loans are not regarded as business 
transactions. Hence these investments are peculiarly a matter 
of community concern. 

In the matter of training, parts of it are of general value, and 
parts are specialized and not transferable from one occupation to 
another. Specialized training is like specialized capital—wasted 
if the possessor shifts his occupation, and partly wasted if he 
works short of his capacity. On the other hand the human 
engine is equipped with faculties for learning new things, and 
these faculties do not disappear as soon as the worker has learned 
one of the limited sets of mechanical processes which constitute 
the modern automatic factory’s substitute for a “trade.” If 
this exploring faculty remains idle, there is a waste as serious as 
many other wastes we have been studying, and for the sake of 
avoiding it, it is worth while to sacrifice some of the value of 
things one has learned. The waste of shifting from job to job 
is real, but must be estimated in the light of the opportunities 
for variety and growth which a single job affords. 

Some workers shift too much; others too little. Sometimes 
a skilled workman could get less skilled work in times of depres¬ 
sion and does not, partly because he feels the cruder work to be 
beneath him, partly because it would spoil the fineness of his 
hand and partly because it would cast doubt on his status as 
a genuine skilled worker in the minds of future employers, thus 
tending to “spoil his market.” So far as the business cycle is 
concerned, if the skilled man took the unskilled job he would 
be taking it from some other man who needed it more, so that 


364 


ECONOMICS OF OVERHEAD COSTS 


the gain to the community would be more than doubtful. 
At such times the “lump of labor” is genuinely limited, and a 
single laborer can do little or nothing to increase it. Needless to 
say, this would not be true where trades with different seasonal 
periods are systematically dovetailed together, whether on the 
initiative of laborer or employer. The advantages of this are 
so obvious that no ordinary craft lines should stand in the way. 

At length we turn to the cost of labor in the sense of alter¬ 
natives sacrificed. As we have seen, if a given hour’s work really 
has a traceable human cost, it is almost always on account of the 
character of the work, compared to some other use which might 
be made of the same time and energy. The cost of giving up 
leisure is the most truly variable element in labor cost. This 
cost has the interesting property of increasing as the rewards 
of labor increase, since it takes money to make leisure worth 
having. The giving up of leisure does not begin to involve any 
cost until the wage has provided for the necessities of physical 
existence and a reasonable stock of energy. Up to that point 

r* 

the worker is in a deficit economy, with fatigue and human 
undermaintenance as the dominant quantities. After the surplus 
point is reached the positive value of leisure increases with the 
funds one has to furnish the means of enjoyment, subject to the 
general law of diminishing utility. Thus the giving up of leisure 
is a variable cost of labor. 

But what about irregular and involuntary unemployment? 
Does this furnish leisure which compensates for the loss in wages ? 
Would a stop-gap job cause the giving up of leisure approximately 
balancing the worth of the wages? Clearly not. Unemploy¬ 
ment is not a vacation, and while it may be made use of by way 
of education, this does not take the place of a steady job, and the 
two are not so incompatible that the job must be given up if 
adult education is to be had. No, when an unemployed worker 
finds a job, the leisure he gives up has no very material value^ 
and costs him no very material sacrifice. 

Aside from the question of job or no job there is the question 
of which job. A man cannot adopt one tiling as his main 
occupation without giving up some other possible product, so 


LABOR AS AN OVERHEAD COST 


36s 


long as there are two products he might make; which means so 
long as there are more things needing to be done than the normal 
working time of the normal working quota of the population will 
suffice to accomplish. One need not ask whether this work is 
worth the sacrifice of doing it, because if part of the normal 
working force is not being utilized, that question settles itself. 
Anything worth doing at all is worth the cost of utilizing “idle 
overhead ” of any sort, material or human. 

Thus there is a sharp distinction between two kinds of case. 
One concerns the mobilization necessary to put industrial 
resources in their proper places and in the proper proportions— 
seeing to it that there is enough and not too much devoted to 
cutting lumber, baking bread, making automobiles, and search¬ 
ing out new forms in which to put our increase of productive 
power. The other has to do with utilizing idle capacity of labor 
and capital whose main occupation is unquestionably sound, so 
that there is no need of permanent remobilization. In the first 
case, the long-run alternative cost of devoting labor and capital 
to one occupation is substantially their full market worth, while 
in the second case the alternative cost of filling idle time is next 
to nothing, unless the supply of auxiliary occupations is equal to 
the demand. And this will not come to pass until all seasonal 
irregularities are dovetailed into each other and the remainder 
reduced to the proportions of satisfactory vacations and reason¬ 
able fluctuations of working speed, and until the still more 
unmanageable business cycle is reduced to similar proportions. 

To sum up the drift of this argument, there are few elements 
of the ultimate cost of labor which vary even roughly in propor¬ 
tion to amount of work done, and those which do so vary are 
chiefly alternative costs or “opportunity costs.” And even these 
are not variable to any great extent when it is a question of 
utilizing idle energy, or rather idle portions of the normal quota 
of time and energy which can fairly be devoted to industrial 
employments. This proposition cannot be reduced to an 
ironclad formula, and must be applied with wise discrimination 
between case and case. Nevertheless if we had to choose 
between two sweeping propositions: one saying that the human 


366 


ECONOMICS OF OVERHEAD COSTS 


cost of labor varies in proportion to work done and the other 
that it is a “constant cost,” the latter would be preferable 
because it expresses those truths of which the present industrial 
system is most oblivious and around which the constructive 
effort of the present generation needs to center. 

4. HOW MUCH UNEMPLOYMENT IS NECESSARY ? 

In this connection one fact needs to be faced which is too 
often slighted, both by business men and economic theorists, 
namely, the fact that mobilization itself implies and requires 
some unemployment. It calls for an “industrial reserve army,” 
both of capital and of labor, though not to the extent nor for 
the reasons which the Marxian theory supposes. To the extent 
that this is really inevitable and essential to industry, it is not 
a waste, though the question still remains how to reduce the loss 
of power to the smallest possible proportions. Therefore we 
must raise the question how much unemployment is really 
necessary for industry; not because there is any immediate 
danger of having too little unemployment, but because this 
question will help toward setting a reasonable goal and toward 
determining who benefits by unemployment and who should 
bear the burden of the irreducible remainder. 

The need for unemployment focuses around nine points, as 
follows: (1) The need of industries to select suitable applicants 
from among the candidates who present themselves, and to 
reject the unsuitable. (2) The need of workers to explore the 
market in order to find the place in which they can be most 
useful and most happy. (3) The need of being able to launch 
new enterprises without actually pulling away too many men 
who are already working in established industries. (4) The need 
—if it really exists—of the fear of losing the job as an incentive 
to make labor put forth as much effort as industry has a right 
to demand. (5) The need—if it exists—of strikes, to protect 
labor’s legitimate interests, or of a replacement force in case of 
strikes, sufficient to prevent the community from being at the 
mercy of organized labor, but not sufficient to put labor at the 
mercy of the cut-throat competition of unemployed workers 


LABOR AS AN OVERHEAD COST 


367 


who must take anything they can get. Aside from a very few 
strikes, these needs are probably not real; certainly the com¬ 
munity needs no unemployed army of potential strike-breakers 
to protect it from organized labor, though it might be worth 
something to have a supply of employed workers, qualified for 
the essential jobs in every trade, but employed in other trades. 
(6) The need of having this reserve of unused trade knowledge 
implies that workers must have moved about from trade to 
trade in the process of acquiring it, and this involves some neces¬ 
sary unemployment, though possibly no more than is already 
implied in laborers finding the places to which they are best 
fitted. (7) The need of a supply of labor to handle seasonal 
peaks and other incidental irregularities in particular industries. 
This implies mobilization, and mobilization implies some unem¬ 
ployment, while there is a further residuum due to the fact 
that the various seasonal peaks cannot be perfectly dove¬ 
tailed together. Here one must distinguish carefully between 
the need of some unemployment and the need of throwing upon 
labor the burden of financing it. The two are separate questions. 
(8 N The need of a reserve to handle the peak of the business cycle. 
Here again, what industry feels as a need is to have this reserve 
without paying for its upkeep during the idle times. To have 
the reserve and pay for it would hardly be felt as a boon. (9) 
The need of throwing upon labor a part, at least, of the burden 
of dovetailing together seasonal occupations and finding work 
in dull times, ( a ) to stimulate laborers to do their best in this 
direction and to make some concessions in order to utilize their 
own idle overhead, and (b) to relieve industry of a financial 
burden which it could not easily bear, and of the necessity of 
regularizing employment to a greater extent than it now finds 
practicable. 

A little consideration of these nine points will show a marked 
difference between the unemployment which persists even at the 
peak of industry and that due to a shortage of work. In the 
former kind, laborers and employers share both the burdens and 
the benefits, and the chief difficulty arises in the case of the 
naturally handicapped. Industries compete for the best workers, 


368 


ECONOMICS OF OVERHEAD COSTS 


and their competition is made keener by the subdivision of labor 
and the use of expensive machinery, since a poor worker can 
slow up a machine which costs far more than his wages, or spoil 
materials into which has gone the work of a dozen men more 
expensive than himself. The presence of large overhead costs 
widens the gap between the productive worth of fast and slow 
workers, and has a tendency to shut out the latter from highly 
mechanical types of work. 

This is natural and perhaps inevitable. These slower or 
less efficient laborers should find those places where their qualities 
put them at the least disadvantage, and they cannot expect to 
earn as much as those who are more rapid and efficient. The 
chief evil arises from the fact that, for the workers who fail to 
find a regular place in mechanical industry, the available places 
are too many of them of the casual sort, so that the burden of 
casual labor is largely concentrated on one class. And casual 
work tends to make casual workers. Thus from him who hath 
not, modem industry takes away even that which he hath. 

The casual worker may be characterized as one who bears 
the burden of his own maintenance during idleness, for the benefit 
of the spasmodic peak demands of industry, whereby industry 
gets the use of his peak capacity without having to pay for the 
idle overhead, while the employee’s task of piecing out his 
maintenance is too difficult to be successfully performed. The 
casual worker himself cannot do anything effective to diminish 
the amount of casual work, but industry can. Therefore, on 
pragmatic principles of responsibility, industry should bear a 
large part of this burden. The cost of the weeding-out process 
whereby industries select the fittest workers is made unduly 
great by leaving the undesirables at the mercy of whatever 
work their disadvantages enable industry to impose upon them 
rather than directing them into a kind of job which will con¬ 
serve and develop whatever limited store of productive power 
they may possess. 

Do laborers require the fear of losing the job in order to 
make them work hard enough ? Many do, it must be admitted; 
and discharge for inefficiency, as a last resort, is a necessary part 


LABOR AS AN OVERHEAD COST 


369 


of any system of labor administration worth prescribing for 
human beings as they are. But discharge on account of dull 
times is a different story and its net effect is thoroughly harmful 
to efficiency. Men work harder in order to hold their jobs, at 
just the time when their efforts can add nothing to the national 
dividend, since the industry cannot market added goods if 
they are turned out. And then when jobs are plenty they 
attempt to prolong that happy state by working as little as they 
dare, at just the time when industry could market additional 
goods if they could only get them to market, and when output 
does actually depend on how hard the workers work. Thus the 
fear of unemployment, so far as it is due to lack of work, has the 
effect of reducing efficiency and output, not increasing it. 

This question leads on to that of unemployment during 
depressions, but before leaving the subject of the unemployment 
which persists even in busy times, it must be noted that there 
is a very real problem of diminishing the cost of the legitimate 
recruiting and mobilization service to which such unemployment 
is incidental. Better organization of labor markets and labor 
exchanges may make it more easily possible to work at one job 
while looking for another, to set the field of employment before 
the worker in clearer and more comprehensive fashion and 
generally to diminish waste motion. This is a true public 
service; an example of intangible overhead in the shape of 
market knowledge, which only a central agency can organize 
to the best advantage. 

As for unemployment resulting from industrial irregularities; 
the necessity of idleness is one thing, and depends on the extent 
to which industry can be regularized. The necessity of letting 
that idleness take the form of “unemployment” as we know it— 
meaning that the worker bears the burden of his own idle time— 
is a very different thing, and amounts to assuming that industry 
cannot be made to bear full responsibility for all the overhead 
costs of which it receives the benefit. The result is that those 
who can do the most to regularize industry do not have the incen¬ 
tive, because they do not bear the worst of the costs of which 
irregularity is the cause. Unemployment in this sense is mostly, 


37° 


ECONOMICS OF OVERHEAD COSTS 


if not entirely, unnecessary, though it will take a long time and 
much painful experimenting to eliminate it. 

In discussing railroad discriminations in an earlier chapter, 
it was argued that the roundabout road whose capacity is needed 
at the peak has an equitable claim to a share of traffic and 
earnings off the peak, even if that means routing some shipments 
by a route which is not the cheapest. On the same grounds the 
worker whose capacity is needed at the peak has at least as 
strong a claim to a share of work and income at other times, 
even if better men sometimes work short of full capacity in order 
to give him a share of their job. 

To sum up: the really necessary unemployment does not 
constitute a serious problem, though its cost should be minimized 
as a matter of economizing idle social overhead. The unemploy¬ 
ment due to business fluctuations is, in its present form, unneces¬ 
sary, and fair social accounting would place a major part of the 
burden on industry, rather than all of it on those classes of labor 
least able to bear it successfully. 

5. COST OF LABOR TO THE EMPLOYER 

Part of the cost of labor is already obviously an overhead 
cost to the employer: namely, the budget of the salaried force, 
and the essential wage-earners who share that security of tenure 
which is the most fundamental mark of the salaried status. 1 
Members of this class expect to adapt their hours to the require¬ 
ments of the business: to work overtime without extra pay, to 
receive a vacation with pay, to be kept on the rolls during 
sickness (within limits), and during dull times. Thus the salary 
budget is virtually constant, and there is a visible movement 
toward extending this status to labor in general. Some go so 
far as to guarantee full yearly earnings, others one-half or one- 
third pay during a lay-off. The Columbia Conserve Co., for 
instance, has for some years placed practically all its permanent 
workers on a yearly salaried basis, and has used many expedients 
in its endeavor—largely successful—to dovetail work together 

1 Cf. G. P. Watkins, in American Economics Review , V, 770-77 (December, 

1915)- 


LABOR AS AN OVERHEAD COST 


371 


so as to avoid unemployment. 1 Their achievement is notable, 
because canning is such an extremely seasonal business, but they 
have not eliminated the need for reliance on casual labor. 

As for common labor which does not get the benefit of such 
an arrangement, the more irregular jobs either get enough 
higher pay than the regular ones, to compensate for their irregu¬ 
larity, or they do not. Generally they do not, and in this case 
the laborer and his family and friends, or the community, are 
paying part of the overhead cost of the industry. If there are 
cases in which the wage fully compensates for the lost time, 
then the industry is paying all the overhead and might have had 
a full year’s work for the same average pay if they had only 
been clever enough to stabilize employment. Even now, if 
work were stabilized, considerable reductions could be made in 
the cost of labor per full day’s work performed, but the gain 
would have to be shared with the laborers. A single employer, 
taking the lead, might have a harder time in realizing the lowered 
labor cost to which he was entitled than the entire industry 
would if they acted in concert. He would find it difficult to 
break away from the general wage conditions as set by his 
competitors, but might be able to do so if he could back up his 
offer of steady employment with a definite guaranty, as numbers 
of employers are now doing. 

In the usual case, wages in irregular jobs are high, but not 
high enough to equalize average yearly earnings; and the 
employer has some incentive to regularize, but not nearly enough. 
Along with this go more general incentives. The desire to keep 
the organization together and the realization of the cost of letting 
it go to pieces, the recognition of the burden of casual labor and 
the fact that those who make free use of such labor bring that 
burden upon themselves, and the slow realization that unemploy¬ 
ment acts as a boomerang—"a cause and not a result of business 
depression,” as one writer emphatically puts it—all these tend 
toward the conclusion that when labor is laid off its cost does not 

1 See W. P. Hapgood, “The High Adventure of a Cannery,” Survey (September 
1, 1923); also Paul Douglas, “A Case of Genuine Industrial Self-Government,” 
University Journal of Business (November, 1922, and February, 1923). 


372 


ECONOMICS OF OVERHEAD COSTS 


disappear; it changes its form, and a very appreciable part of 
it comes back to plague the same industry which started the 
vicious circle by laying off its workers. One industrial manager 
testifies that our “orgies of hiring, firing, and hiring again are, 
we notice, infinitely more expensive than more or less stabilized 
production.” 1 This burden, of course, is diffused. Each 
employer feels the effects of what all the others do, and only a 
part of the effects of what he does himself, whether for good or 
ill. Thus the overhead cost of labor is a collective burden upon 
industry in general, but the market does not allocate to each 
employer the share for which his own enterprise is responsible. 

6. THE BURDEN OF UNEMPLOYMENT 

Unemployment is difficult to measure, owing to the difficulty 
of defining full employment, but the average amount of time lost 
has been estimated at from 13 per cent to 14 per cent of full 
time. 2 Of this amount strikes are responsible for a variable 
proportion, less than 1 per cent, while sickness accounts for about 
2 per cent—more for women and less for men. 3 This leaves 
something like n per cent to cover cases in which the worker 
does not want the job or the job does not want the worker, but 
chiefly the latter. Professor King’s figures indicate that the 
number of whole days lost because work was not available 
averaged about 10 per cent of full time for male workers during 
1920-22, ranging from 4 per cent to 15 per cent, approximately, 
between the busiest and the dullest three-month periods. The 
minimum loss from this cause may be estimated at about 4 
per cent of full time. This represents chiefly seasonal unemploy¬ 
ment and chronically casual work, which even busy seasons 

1 Ernest G. Draper, in pamphlet entitled “Unemployment,” reprinted from 
the New York Times of September n, 1921. 

2 See Percy and Albert Wallis, Wages , Prices and Profits. Also estimates by 
Massachusetts Department of Labor and United States Commissioner of Labor, 
and some figures given in W. I. King’s “Employment, Hours and Earnings in 
Prosperity and Depression,” National Bureau of Economic Research (1923), esp. 
p. 73. Professor. King does not, however, attempt a definite estimate of the 
absolute volume of unemployment, confining his study instead to changes in the 
volume of employment—a more tangible quantity. 

•’See W. I. King, op. cit., pp. 72-73. 


LABOR AS AN OVERHEAD COST 


373 


do not cure of all lost time. The total effect of depressions is 
best expressed by King’s estimate that the crisis of 1921 reduced 
the volume of employment in the United States by one-sixth. 1 

This grand total, large as it is, gives no idea of the real 
problem of idle time for labor. In the first place, it does not 
show the very heavy seasonal unemployment. Agriculture, for 
instance, shows almost no reduction due to depression; its lost 
time is wholly a seasonal matter and falls naturally on the class 
of hired employees, so that they bear more than their share ot 
the total seasonal fluctuation of work. The number working in 
the first quarter of the year is only 58 per cent of what it is in 
the third quarter. This figure varies considerably from section 
to section, the South showing the least fluctuation and the Rocky 
Mountain section the most, while day laborers fluctuate more 
than laborers hired by the month. In the mountain region there 
are more than eight times as many day laborers in the third 
quarter of the year as in the first. 2 Kang’s estimate that the sea¬ 
sonal rise and fall amounts to 900,000 seems quite conservative. 

The fitting of these 900,000 into other seasonal occupations 
would constitute an enormous task of mobilization even if other 
occupations expanded their requirements in just those months 
when the need on the farms is dwindling. But unfortunately 
there does not appear to be any such general seasonal compensa¬ 
tion. When the farm did much of its own manufacturing, such 
work was naturally done when the pressure of farm work was 
lightest. This meant a low load factor for the simple equipment 
used, but that was negligible compared to the time of the workers 
themselves. Industrialized manufacturers are not so con¬ 
siderate; they work according to demand instead of according 
to the time when the pressure of other kinds of work is light and 
hands are idle. The farmer himself does not time his purchases 
as he would time the making of those same goods if he had to 
make them on his farm. He suits his convenience, not the 
seasonal curve of employment. 

Thus industry as a whole simply does not make room for these 
900,000, unless it changes its schedule so as to do so. It is a 

1 Ibid., p. 53. 3 Ibid., pp. 37-38. 


374 


ECONOMICS OF OVERHEAD COSTS 


mockery to invite them to dovetail their harvest jobs with others; 
they cannot make the jobs, and they are simply being lured into 
the man-trap of casual labor. This is, of course, not true of 
all individuals, but the statistics show it as an inexorable fact 
for hundreds of thousands. Construction w T ork and transporta¬ 
tion, especially railroad maintenance of way, have a seasonal 
curve similar to farming, and tend to aggravate the incorrigible 
discrepancy between supply and demand. 

Aside from seasonal unemployment, the grand totals for years 
of prosperity and depression do not show r how the burden is 
concentrated in certain industries and certain classes of establish¬ 
ments. While the general ratio between boom and depression 
is 6:5, mining, steam railways, and factories as a whole all show 
cyclical declines of close to 30 per cent from 1920 to 1921-22, 
the manufacture of metals and metal products showing over 
50 per cent. 1 Still more remarkable is the fact that there is 
vastly more unemployment in large establishments than in small, 
industry by industry, and that the typical falling-off in employ¬ 
ment in large industry was well over 30 per cent, with large-scale 
agriculture not far behind and mercantile enterprises showing 
relatively great steadiness. 2 Out of 4,100,000 workers removed 

1 W. I. King, p. 55. 

7 Ibid., pp. 55-58. The following figures show the maximum percentage of 
cyclical decline in hours worked, 1920-22, for different industries in enterprises of 
different sizes. 


Industry 

Number of Workers per 
Enterprise 

Less than 21 

21 to IOO 

Over 100 

Agriculture. 

4.28 

0. 

14.66 

0. 

17-35 

41-31 

15.11 

0. 

25-93 

30.18 

4693 

25.58 

38.18 
8.17 

777 

10.84 

3856 

Extraction of minerals. 

Building and construction. 

Finance. 

Steam railways. 

Other transportation. 

Wholesale trade. 

Retail trade. 

3-72 

0. 

1 -31 

8.21 

9.80 

12.31 

4.66 

19.21 

Factories. 

All industries. 

3.08 

13-84 

28.23 


The figures for the decline in number of employees on the pay-rolls are about 
four fifths as great, indicating that about one fifth of the burden takes the form of 
part-time work 


























LABOR AS AN OVERHEAD COST 


375 


from the pay-rolls on account of depression, 3,300,000 came from 
concerns employing over 100 workers in the first quarter of 1920, 
some 500,000 from those employing between twenty-one and 
100, and something over 200,000 from those employing less than 
twenty-one workers. 1 When one remembers that the most 
skilled and experienced employees are kept on through a depres¬ 
sion one wonders how the least valuable quarter of the workers 
in large industries get along at all. And there must always be a 
least efficient quarter! 

How shall the cost of this irregularity be measured? One 
possible measure is the productive worth of the time lost, if 
that could in turn be measured. Not all of this idle time could 
be redeemed, but the major part of that caused by the business 
cycle is potentially redeemable. If the nation were a business 
firm it would set a goal or standard toward which to work. 
Any such goal which might be set would call for a saving of at 
least 5 per cent of the nation’s working power, averaging good 
years with bad, even if the objective were merely half-time for 
everyone formerly unemployed on account of lack of work. 
Another measure would be the maintenance expenses which 
labor must try as best it may to meet during idleness. Here 
it is worth while recognizing both the whole amount of idle 
overhead which labor has to try to meet, due to all causes, and 
also the avoidable part of it. 

Estimating average unemployment from all causes at 
4,000,000 and average cost of maintenance of the unemployed 
and their dependents at $1,200 per year, we would have a total 
“idle overhead” of $4,800,000,000 which labor or someone else 
must finance, if it is financed at all. Taking the maximum 
decrease in number of workers employed due to both seasonal 
and cyclical causes at 5,000,000, and estimating the cost of 
maintenance at the same rate, the burden would be $500,000,000 
per month at the worst period of a depression. Under favorable 
conditions labor can and does successfully finance a large part 
of this burden, and there is no reason for attempting to take it 
all from their shoulders. But the total amount, unevenly 

1 Ibid., pp. 30-33. 


376 


ECONOMICS OF OVERHEAD COSTS 


distributed as it is, is altogether too heavy to be successfully 
borne by those groups on whom the incidence is heaviest. 

The manner of bearing it varies. Chronic casuals with only 
themselves to look after may get along for considerable periods 
on as little as 50 cents per day, and weather a hundred days of 
winter on considerably less than $100, but not without serious 
harm to their working powers, physical and mental. Men with 
families to feed and rent to pay require much more. Aside 
from their savings, they are often carried on credit by the grocer, 
or helped out by friends and neighbors in other ways. Behind 
these stands organized charity, whose budget shows a vivid 
picture of the ups and downs of employment. For instance, the 
Associated Charities of Cleveland in five pre-war years cared 
for twice as many families in midwinter as in midsummer, and 
from the fall of 1920 to the end of the winter of 1921-22 the 
number increased fourfold. 1 It seems a conservative estimate 
that more than half the burden of organized relief is really a 
cost of seasonal and cyclical fluctuations in industry, and that if 
this amount were thrown upon industry directly, it would still 
be only a small fraction of the loss for which these fluctuations 
are economically accountable. 

7. METHODS OF DIMINISHING THE BURDEN 

Remedies for this evil are many, some private and some public; 
some looking toward diminishing unemployment and some merely 
toward compensating the victims or insuring them. The most 
hopeful symptoms, and those most in harmony with the trend 
of the present study, are those which indicate that the employers’ 
sense of responsibility toward their problem is undergoing a 
process of crystallization into more and more definite forms. 
It is only within recent years that this appears to have been 
regarded as a task peculiarly incumbent upon the managers of 
industry as such, by virtue of their position, their resources and 
their opportunities, and not merely a matter of personal charity. 
More recent is the growing sense that this is a cost of industry, 
occasioned by industrial irregularity, and that it must be borne 

1 Survey (September 15, 1923), p. 716. 


LABOR AS AN OVERHEAD COST 


377 


by industry in the last analysis. Still more recent is the dawning 
consciousness that particular industries have some responsibility 
for the idle overhead of the workers they employ at the peak, 
and that a considerable part at least of this burden can be 
successfully borne by industries in the regular course of their 
industrial operations. If this belief grows stronger, it is not 
unthinkable that this vague community overhead should be 
allocated to industries and divided among the partners concerned, 
in really workable fashion. 

At present, the laborer’s chief weapon for actually diminishing 
unemployment is to submit to a cut in wages sufficient to make it 
economically worth while for employers to hire him. The 
employers would, of course, be expected to accept a corresponding 
paring-down of profits and the resulting reduction of prices 
might do a great deal to stimulate off-peak business. The basic 
idea of this proposition is logical and sound. Labor has every¬ 
thing to gain by making it possible for the employer to use the 
time that is now idle without paying the full prosperity wage for 
it, provided this can be done without establishing the special 
low rate as a new standard wage applicable to all work. This 
would be “spoiling the market” for labor with a vengeance, and 
would be likely to mean that the ground painfully gained through 
costly strikes would be given up, so that when business revived 
the whole struggle would have to be fought over again. Thus it 
is easy to see why labor should attempt to defend its rates and 
protect its overhead even at the expense of unemployment. 

In order to avoid this dilemma, it would be necessary to estab¬ 
lish a clear-cut separation between normal wages, which must 
be adequate to cover labor’s maintenance, and special reductions 
made to stimulate off-peak business and avoid unemployment 
and not required to cover their full share of labor’s overhead 
costs. Both would need to be recognized parts of the same 
scheme of wage rates, so that wages could return to normal when 
conditions justified it without the necessity of a new bargain 
and the struggles and probable strikes attendant upon it. This 
dual system of wages would be enormously difficult to establish, 
especially in the case of casual labor, which is partly unemployed 


378 


ECONOMICS OF OVERHEAD COSTS 


at all times. The casual laborer simply could not charge a 
wage rate high enough to compensate for his irregular work and 
at the same time decrease his percentage of idle time by selling 
his services for “what the traffic will bear” to employers who 
might furnish additional work. The laborer is not like a great 
company, able to discriminate and to make up its overhead 
costs on part of its business while granting concessions on the 
rest. 

The privilege of obtaining work for less than a living wage 
is a dangerous one to experiment with, unless the shortage 
between wages and cost of living is already underwritten, or 
somehow provided for. Not only are employees unwilling to 
accept such wages; employers are reluctant to grant them, and 
with good reason, under existing conditions. For regular wages 
are not high enough to permit labor to accumulate adequate 
reserves to finance the family through periods of starvation 
wages, and if wages were adequate to this purpose, still there 
would always be a large group who had not made adequate 
provision, for one reason or another. Thus they would still 
have to finance themselves out of current earnings, and the 
employer cannot afford to pay wages on which it is clearly and 
admittedly impossible for labor to live. Such a policy would 
amount to cut-throat competition on the part of labor, in spite of 
the most strenuous efforts to prevent. 

Furthermore, organized labor is engaged in a continuous 
campaign to increase the share of the product which goes as 
wages, and looks at the immediate situation from the standpoint 
of its effect on this paramount undertaking. Thus they strive 
to raise wages in prosperous times, when demand will permit it, 
and to keep them from falling in dull times, so that the next rise 
may start as nearly as possible where the last one left off. Thus 
the settled policy of organized labor is chiefly governed by the 
determination to protect labor’s overhead by keeping wages up, 
rather than to utilize idle overhead by adjusting them to the 
ups and downs of demand. Thus all wages are loaded with 
their share of labor’s idle overhead, and additional labor in 
dull times costs the employer more than it costs the laborer. 


LABOR AS AN OVERHEAD COST 


379 


with the result that work which would be worth doing remains 
undone. 

It goes without saying that such a generalization as this 
cannot be an accurate description of anything so many-sided as 
the labor market and labor policy. Many exceptions need to 
be made. Especially where there is something like a relation 
of genuine partnership between employers and employees, 
labor often voluntarily accepts a cut in wages in order to enable 
the industry to keep running. Such concessions are, however, 
limited by the general rule that wages, even under such conditions, 
must cover the necessary living of the laborer, and the differential 
cost of labor to the employer remains higher than its cost to the 
laborer. 

In spite of all the difficulties in the way of removing this 
obstacle to full employment, it is possible to adjust the wage 
relation so as to cure the worst of the evil, where the employee 
has a regular position, such as would be furnished by a yearly 
contract. Here it is possible to arrange such terms that, within 
limits, the differential cost of added labor to the employer is 
low, while the laborer is not dependent on this low differential 
rate to cover all his living expenses. Where laborers are on a 
salary basis, this of course settles the problem so far as they are 
concerned. But as it would be impossible for industry to carry 
all of its workers on this basis, the workers who are in most need 
of such provision would not be directly affected, and could only 
benefit indirectly where the system resulted in a general stabiliz¬ 
ing of work in the entire industry. 

i Another plan is to guarantee a minimum of employment for 
a given period. In 1912, Swift & Co. introduced a minimum 
weekly wage equal to forty hours’ pay for all employees on the 
pay-roll at the beginning of the week, and other packers have 
followed this example. This of course would not prevent a 
seasonal lay-off, but it seems to have had some good results, 
aside from the obvious benefit to the men of knowing what wages 
they could count on. The employers are said to have become 
more careful of the quality of laborers they hire, and they have 
taken steps to secure the co-operation of railroads and shippers 


38° 


ECONOMICS OF OVERHEAD COSTS 


of live animals toward regularizing the receipts at the packing¬ 
houses, distributing them over the week instead of concentrating 
them heavily in two or three days. 1 A number of employers 
have guaranteed yearly earnings, some at full rates and some 
at one-half or one-third rates during lay-offs. 2 

The Cleveland Ladies’ Garment industry in 1919 set its face 
toward regularization in a joint agreement of employers and 
employees, and the outcome was a plan which went into operation 
in June, 1921, whereby if a company fails to furnish twenty 
weeks’ work in any half-year, it pays wages for the shortage at 
two-thirds the minimum union rate, out of a fund created by 
setting aside 7! per cent of the direct labor pay-roll each week. 
If the fund is exhausted the employer’s obligation ceases. This 
means that the employee can be out of work for six weeks before 
the company’s guaranty becomes effective. 3 Thus the employee 
has an incentive to look for a job, and the employer can save 
as much as per cent on his direct labor bill by furnishing fairly 
regular work, as compared to a competitor who only furnishes, 
let us say, thirty-five weeks’ work in a year, and thus uses up 
his unemployment fund. Here the employee bears, on the face 
of the agreement, a larger part of labor overhead than the 
employer, being liable to the extent of six weeks out of twenty-six 
or 23 per cent of full time, while the employer risks only 7J 
per cent on the time he actually works. It will require much 
experimenting to divide the burden so as to avoid laying a 
crushing weight on either party, while giving as effective a 
stimulus as possible to reduce irregularities. 

The Dennison Manufacturing Co., a pioneer in the regulariza¬ 
tion of highly seasonal labor, carries a fund raised by joint 
contributions, and Mr. Henry S. Dennison, the president of the 
company, states: “Upon a fairly large class of goods we found 
it would be cheaper to manufacture to stock and store for long 
periods than to pay unemployment relief for idleness.” 4 This 

1 John Calder, Survey (October 15, 1922), p. 95. 

2 National Industrial Conference Board Bulletin 43. 

3 Survey (January 14, 1922), pp. 594-95* 

% 

4 See American Labor Legislation Review (March, 1921), pp. 41-47 and 53-59; 
ibid. (March, 1922), p. 34. 


LABOR AS AN OVERHEAD COST 


3 Sl 


puts the policy of making to stock on a business basis to the extent 
of making it the lesser of two financial evils, but does not furnish 
funds to carry it on. As we have seen (chap, ix), of two possible 
policies the lesser evil may still never yield a positive profit, 
but merely avoid a larger loss. Such policies cannot be financed 
without reserve funds. Thus the next step is to use the unem¬ 
ployment fund, under proper regulations, to help finance produc¬ 
tion which will save the fund from being depleted, and Mr. 
Dennison mentions this as a proposal containing a suggestion, 
at least, of a policy of insurance against the depression phase of 
the business cycle. 1 

Ordinary insurance against unemployment would mean that 
each employer and each industry insured its workers, and the 
insurance fund or company paid the benefits. This would have 
the great defect of leaving the obligation too general, unless 
there is provision whereby the individual employer’s premiums 
vary directly with the disbursements which his own enterprise 
occasions. On the whole it would be more normal if each enter¬ 
prise had its own fund and insured itself against the possible 
exhaustion of that fund. 

Another method of making the employer pay something for 
labor’s idle overhead is the simple requirement of a month’s 
pay on dismissal, or other similar bonus. This system is 
already customary in some occupations. It is a very rough- 
and-ready measure, and the payment may be unnecessarily 
large in some cases and not large enough in others. It might 
have some usefulness in giving the employer an incentive to 
divide up a shortage of time among his laborers rather than to 
let some go entirely, and this is a beneficial thing, so long as it 
is a matter of a seasonal or a chronic oversupply of labor. Such 
a measure should be judged in connection with other possible 
measures for allocating labor’s overhead, and not as a thing by 
itself. 

If the employer becomes in adequate measure responsible 
for the idle time of the workers his industry requires, this removes 
the chief objection to the policy whereby each industry has its 

1 American Labor Legislation Review (March, 1Q22), p. 34. 


382 


ECONOMICS OF OVERHEAD COSTS 


own private reserve of labor, more or less isolated from the general 
market. An employer is entitled to keep a claim on his workers’ 
time through periods of idleness, provided he pays a fair price 
for the privilege, covering its cost to the worker. But while 
the responsibility for compensation may be individualized, the 
work of finding jobs for the inevitable remainder of jobless can still 
best be done if the various contingents of unemployed are 
merged into one mobilizable army. Seattle longshoremen have 
recently been definitely organized in gangs under a joint organiza¬ 
tion of employers and employees, and classified into “company 
gangs,” which represent the labor for which each company 
undertakes to assure reasonably steady work, and “hall gangs,” 
constituting a single reserve for the whole industry, mobilized 
from a central dispatching hall. This organization has also 
enormously reduced the supply of labor so that the remainder 
can share their idle time and still earn vastly more than previous 
average wages. This was done largely by keeping out “floaters” 
who left the docks and then wished to come back, and also by 
eliminating the least competent. The total number registered 
was reduced from 1,420 in September, 1920, to 612 in August, 
1921, but as 1921 was a year of heavy business depression some 
allowance should be made in interpreting these figures. 1 

This case illustrates one corollary of assuming responsibility 
for idleness as part of the unabsorbed overhead of the industry: 
namely, a great reduction in willingness to employ distinctively 
casual labor. And since labor becomes casual chiefly because 
people employ it on casual work, the natural result must be a 
diminution in the number of casual workers and their segregation 
into a fairly well-marked class. Both these conditions are 
favorable to successful handling of the peculiar difficulties of 
distributing and financing the costs of this type of labor. 

This very brief discussion has aimed not so much to treat 
of methods of reducing unemployment as of the general economic 
status of such methods and the economic incentives available 

1 For data on this Seattle experiment see the Survey (October 15, 1922), pp. 96- 
97. Statement prepared by the joint Executive Committee of the longshoremen 
and employers. 


LABOR AS AN OVERHEAD COST 


383 


to promote them. Broadly speaking, any measures for the cure 
of unemployment cost comething, and are a recognition of the 
fact that the cost of idleness—the unabsorbed social overhead 
of labor—is greater than the cost of finding work. The commu¬ 
nity will probably always continue to bear a considerable part 
of this cost, but there is an increasing tendency to regard it as 
an industrial expense. Mr. Dennison, who has earned the right 
to be regarded as an authority, puts it in these words: 

It is better social cost-keeping to add the overhead burden of unem¬ 
ployment to those goods which are responsible for irregular employment 
than to draw it from the savings of the working group. The whole burden 
put upon wage-earners and reacting upon their knowledge of their helpless¬ 
ness to affect its causes, arouses resistances and irritations which make 
smooth running of the social organization impossible. Industry has a con¬ 
siderable share in the opportunities for mitigation of unemployment, hence 
industry must be spurred to their exercise by carrying part of the burden. 1 

Mr. Calder lays down three propositions: each industry needs 
a surplus of labor; the surplus, for the social good, should be 
kept as small as possible; and it should be carried at the expense 
of the industry. 2 One might add that where it is genuinely 
possible for the casual demands of different industries to be 
dovetailed together to any important extent, these industries 
would have an adequate reason for merging their liability. 

Evidently industrialism is in process of evolving a new 
principle of economic responsibility. 3 In the next chapter there 
will be something more to say about measures for diminishing 
unemployment, when we take up the greatest single source of 
waste productive capacity and unnecessary idle overhead: 
namely, the business cycle. To see this great problem in a true 
perspective, it is absolutely essential to keep constantly in 
mind the facts with regard to the ultimate sacrifices of labor 
which the preceding discussion has very imperfectly set forth. 

1 Henry S. Dennison, president of the Dennison Manufacturing Co., in Ameri¬ 
can Labor Legislation Review (March, 1922), p. 32. 

2 John Calder, Survey (October 15, 1922), p. 96. 

3 Aside from the examples already mentioned, the Walworth Manufacturing Co. 
has done pioneer work in the regularization of labor, while no discussion would be 
complete without recognition of the work of B. Seebohm Rowntree, as employer 
and writer (see especially The Human Factor in Business , Industrial Unrest , etc.). 


3 8 4 


ECONOMICS OF OVERHEAD COSTS 


8 . CONCLUSION 

In conclusion, this chapter has discussed many ways in 
which the costs of labor may be viewed, from fatigue to the 
financial outlays of industry, and has found a decisive element 
of overhead cost in all of them. If there is a chance to employ 
labor to good advantage in some other occupations, then to 
keep it where it is involves a genuine sacrifice. But we have seen 
that in times of general shortage of work there is no such resource 
available to the great mass of unemployed. The human cost 
of any decent job is less than that of walking the streets looking 
for work, to any worker not already demoralized by unemploy¬ 
ment. In this sense, labor has no differential cost; so that 
whatever ultimate cost there is must be regarded as an overhead 
burden. 

Of course, labor does feel fatigue, enjoy leisure, seek variety, 
and find an elastic rhythm of activity more salutary than an even 
monotony. Not all the costs of labor are constant, and the 
laborer cannot stand the kind of load factor which would repre¬ 
sent absolute efficiency in the case of a machine. But the 
idleness bred by modern industry goes so far beyond any reason¬ 
able need for variety that it is a clear evil. If we ever gain 
effective control of it, it may then be time to ask how far we 
should go in eliminating it, and where we should stop. But at 
present that is an academic issue. 

In short, there can be little question as to whether labor is or 
is not an overhead cost for all purposes concerned with unemploy¬ 
ment. The only question is as to the best distribution of the 
burden—the best form of social cost-accounting. And on this 
point a change is visibly making headway in industry—a change 
which may end by revolutionizing our customary ways of 
looking at expenses and financial responsibilities. The distribu¬ 
tion of labor’s overhead costs can no longer be left to the stipula¬ 
tions of the customary wage contract; it must be remodeled in 
the light of essential justice, and of the principle of placing 
burdens and incentives where they can do the most good in 
bringing about the action which community efficiency demands. 


LABOR AS AN OVERHEAD COST 


385 


All of which may be little more than a complicated way of 
saying that waste is waste; that anything worth doing is worth 
that much more than nothing and that any means by which our 
wasted productive powers can be salvaged is economically 
justifiable. But we have formed the habit of subjecting such 
questions to the further question: Does it pay ? Does economic 
value cover economic cost? And in order to have economic 
standing, a discussion of these wastes must necessarily be cast 
in this mold. Having once set out to weigh values and costs, 
there is nothing for it but to probe through the fallacies, shiftings, 
and distortions of the conventional financial calculus, and to 
carry the analysis far enough to show that, in the end, it does 
not give the lie to common sense. 



CHAPTER XIX 

OVERHEAD COSTS AND THE BUSINESS CYCLE 

SUMMARY 

Introduction, 386—The concentration of capital expenditures, 389—Other 
causes at work, 396—The shifting and conversion of overhead costs, 397—Steadying 
prices versus steadying production, 403—Remedies for the business cycle, 407— 
Reactions and consequences, 413—Conclusion, 415. 

I. INTRODUCTION 

It is needless to point out that overhead costs play a funda¬ 
mental part in the behavior of business at every stage of that 
many-sided phenomenon, the business cycle. The part they 
play is most paradoxical. For they make regular operation 
peculiarly desirable and peculiarly profitable, so that business 
feels a definite loss whenever output falls below normal capacity, 
and yet it is largely due to this very fact of large fixed capital 
that business breeds these calamities for itself, out of the laws of 
its own being. And the largest businesses, which have the highest 
percentage of constant costs due to invested capital, are, as we 
have seen, precisely the ones which fluctuate the most, so far as 
employment is an index. There is something about the 
commercial-industrial system which bewitches business so that 
it does just the thing it is trying to avoid, and is held back from 
doing just the thing it yearns to do—maintain steady operation 
and avoid idle overhead. And while the contributing causes of 
this strange auto-hypnosis are many and of varied character, 
technical, financial, commercial, and psychological; the underly¬ 
ing fact of large capital plays a central part, and the inelasticity of 
costs, sunk costs, and the shifting and conversion of overhead 
costs are all facts of major importance. 

It is out of the question, in the limited space available, to 
present a rounded discussion, and such a discussion would be 
aside from the main purpose of our present study. 1 It will be 

1 If the reader wishes to make a thorough study of this subject, he cannot 
adopt a better guide than W. C. Mitchell’s Business Cycles. This book not only 

386 



OVERHEAD COSTS AND THE BUSINESS CYCLE 


387 


sufficient here to consider chiefly those factors which have to do, 
directly or indirectly, with overhead costs. In the first place, 
there is the fact that costs and profits depend upon output and 
hence upon demand, quite as much as upon productive efficiency. 
One result of this is that the producer has a wider option in price 
policies than he would have if volume of sales had no effect on 
cost of production per unit. If demand increases he can make 
increased profits without raising prices, if he sees fit, or he can 
raise them with a view to making up the uncovered overhead 
resulting from previous periods of depression. Next there is 
the concentration of capital expenditures and the accompanying 
intensified fluctuation in the demand for capital goods and in the 
output of the industries producing them. This operates in 
connection with the fact that an increased demand for one 
commodity (if not neutralized by decreased demands for others) 
results in a further general increase in demand, though giving 
the producers of that one commodity more purchasing power. 

Another fact is the shifting and conversion of overhead costs, 
which arises when goods are passed on from industry to industry, 
so that the financial accounts of the separate industries distort 
the true proportions of constant and variable costs in industry 
as a whole. Further elements of rigidity in costs are connected 
with standing contracts for goods, and with the lagging response 
of wages and interest rates to the upward movement of prices 
and business earnings. Another fact is that the demand for 
goods consists partly of demand for future use, and is affected 
not so much by the absolute level of prices as by the direction 
in which prices are expected to move. And finally, when costs 
of production rise, the critical thing is not the rise taken by itself, 
but the position in which it catches producers in undertakings to 
which they are committed. All these elements play their part, 
along with the business form of mob psychology, the capacity 
of the credit system for expansion and shrinkage, the distribution 

marks an epoch in the study of the business cycle but is a landmark in the progress 
of inductive methods of economic study. See also studies by O. M. W. Sprague, 
B. M. Anderson, W. W. Stewart, jr., H. L. Reed, and Business Cycles and 
Unemployment , National Bureau of Economic Research, W. C. Mitchell, director. 



3 88 


ECONOMICS OF OVERHEAD COSTS 


of purchasing power, and other things jointly responsible for the 
disease of intermittent paralysis from which industry suffers. 

Viewed broadly, this disease appears to be a joint resultant 
of special disturbing forces, mostly external to industry, and of the 
internal laws of the business mechanism itself. By external 
causes are meant such things as wars, the influence of weather 
on the crops, an earthquake, or a change of any sort in consumers’ 
desires. Inventions and the growth of new industries are not 
external to the economic system, but they are not part of its 
routine operations. They are special events, each one unique 
of its kind. Some writers have emphasized the external forces, 1 
but most theories have attempted to explain how industry brings 
these evils on itself. The detailed study of the history of cycles 
makes it plain that all have similar features, indicating the opera¬ 
tion of the regular laws of the business organism; and yet no 
two are exactly alike, indicating that outside disturbances or 
other special causes play an appreciable part. 

Whenever business starts moving in one direction, the 
movement shows a strong and definite tendency to reinforce 
itself in cumulative fashion and to keep on at an accelerating 
pace until its momentum carries it beyond the point of equi¬ 
librium, if such a thing exists, and reaches its limit only after 
having gone so far that a reaction is inevitable. The distinguish¬ 
ing characteristic of economic forces of the supply-and-demand 
variety, as usually analyzed in economic theory, is that they are 
self-limiting; the more they prevail the weaker they become, and 
the stronger grows the resistance. The business cycle shows 
unmistakably that the forces at work there are not self-limiting 
in the typical fashion but self-reinforcing throughout a great 
part of the swing of the pendulum. Ultimately, limiting forces 
make their appearance, but not until long after the mid-point 
of the swing is passed. The whole motion is suggestive, not so 
much of a pendulum as of that kind of oscillating electric fan 
which trips a reversing plane near the end of each oscillation and 
then swings back until it trips the plane again. The thing which 

x The outstanding example is the Jevons sun-spot theory, and the more recent 
theory of climatic cycles developed by H. L. Moore. 


OVERHEAD COSTS AND THE BUSINESS CYCLE 389 

most needs explaining in the business cycle is why the forces 
of supply and demand work in this cumulative fashion. Mob 
psychology explains much of it, but it also has a more rational 
basis in objective economic facts, especially those concerned 
with investments of fixed capital. 

2 . THE CONCENTRATION OF CAPITAL EXPENDITURES 

Expenditures and additions to capital equipment are pro¬ 
verbially postponable. This means that under farsighted and 
public-spirited management, they can be distributed so as to give 
the builders of plants and the makers of machines reasonably 
steady employment; or that under ordinary management 
expenditures may be so concentrated as to give the makers of 
machines a very bad load factor indeed. As things are, this 
type of demand is extremely irregular, so much so as to constitute 
one of the major disturbing elements in our entire economic 
order. 

The observed facts which bear upon this question are, in 
general, as follows: The demand for means of production fluctu¬ 
ates more violently than that for finished consumers’ goods, and 
also appears to fluctuate sooner, taking the lead in a way which 
would suggest that its changes are a cause, rather than an effect, 
of the changes in consumers’ demand. In point of fact they are 
both effect and cause, as we shall see in a moment. Something 
similar is true of raw materials as compared to finished goods, 
while wholesale prices fluctuate more than retail. 1 These facts 
all point in the same direction, and can be accounted for on a 
consistent hypothesis. 

For the intensified fluctuations in producers’ goods there 
appear to be two main reasons, aside from the force of psycho¬ 
logical suggestion. One is financial; the other wholly inde¬ 
pendent of the money economy. In the first place, postponable 
expenses tend to be timed according to what seems the most 
profitable policy. This means that they are hastened on a 

1 These phenomena are described and analyzed at length in Mitchell’s Business 
Cycles , already referred to. The central importance of construction work as a 
cause of cycles is the basis of Hull’s theory. See Geo. H. Hull, Industrial Depres¬ 
sions. New York, 1911. 


390 


ECONOMICS OF OVERHEAD COSTS 


rising market in order to buy before the price goes up still farther, 
and retarded on a falling market in order to wait and buy at 
still lower prices. Thus rising prices stimulate demand, and 
falling prices check it, at least for the time being. Hence a rise 
tends to cause a further rise, and vice versa; and if enough people 
expect prices to move in one way, that may of itself bring the 
movement to pass. 

But aside from all questions of buying at the cheapest time, 
the physical need for new equipment shows a tendency to fluctu¬ 
ate more intensely than the demand for the finished product, 
because it depends, not upon the total volume of demand, but 
upon the rate of growth (or shrinkage): the amount added, for 
example, during the current year. In other words, the velocity 
of output in the capital-making industries depends, not on the 
velocity of output in the industries which use the capital to 
make goods for consumption, but on its acceleration. Since 
this is bound to be a minus quantity nearly half the time, even 
if the demand for finished products never completely stops 
growing, it is easy to see that the makers of capital equipment 
are bound, in the nature of the case, to suffer an absolute decline 
in the demand for their products, not only semi-occasionally, but 
chronically, whenever ultimate demand slackens its rate of 
growth. And if the demand for finished products stops growing, 
the need for additional equipment naturally falls to zero, while 
a relatively slight decline in the demand for consumption means 
that the need for additional equipment becomes actually a 
minus quantity. It would then be economical to unmake some 
of the equipment and something like this actually happens in 
extreme cases, for equipment is allowed to wear out without 
being fully replaced. 

Once demand for finished products starts growing it cannot 
pause or else the derived demand for means of production will 
shrink, and when it shrinks, the resulting unemployment will 
produce a shrinkage in the primary demand. Apparently the 
interrelations of business are such that a growing demand cannot 
slacken its growth without bringing on itself an absolute diminu¬ 
tion. It must keep on growing in order to stay in the same place! 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


391 


This feature of our economic organization is one with which the 
Red Queen might feel at home, but ordinary human business 
managers are like Alice in the Looking-Glass country, and find 
it hard to learn to turn their backs upon their obvious objective 
in order to reach it; that is, to buy equipment when they have 



years 1 2 3 456789 10 

AA' = Demand for ultimate product. 

BB' = Derived demand for equipment. 

CC'=Work of making equipment. 

DD' = Equipment in service, in terms of normal capacity. 

Vertical dimension shows quantities demanded or produced, 
$000 omitted. 

no immediate need of it and when funds with which to buy it 
are scarce. Instead, they commonly keep aiming toward the 
garden of prosperity, only to find themselves walking in at the 
door of depression and unemployment. Such are the pranks 
which the Iron Slave plays upon his supposed masters! 

The principle at work is illustrated in Chart VII, which repre¬ 
sents a hypothetical manufacturing industry in which equipment 



















































392 


ECONOMICS OF OVERHEAD COSTS 


is equal to twice the amount of the value annually produced 
by the manufacturing process—a typical proportion. If this 
equipment lasts twenty years, the annual replacements will 
equal io per cent of the annual value product, and this figure is 
supposed, for simplicity, to remain steady, since its fluctuations 
would not be sufficient to change the dominant movements. 
Changes in prices are also ignored, for purposes of this preliminary 
diagram. 

In the first year the primary demand (the upper solid line) 
is shown stationary. In the second year it rises 5 per cent. 
In order to furnish 5 per cent additional equipment, however, 
the output of equipment would have to be doubled, and two 
dollars’ worth of extra equipment would have to be made for 
every dollar’s worth of extra finished product turned out. If 
the whole economic system were an impersonal machine, with 
no psychological or financial complications entering in; and if 
it took no time to make the equipment, this is exactly what 
would happen. In the third year, primary demand grows 10 
per cent 1 more and the derived demand is now three times its 
original amount. In the fourth year, primary demand stops 
growing, with the result that the derived demand (the lower 
solid line) not merely stops growing, but falls back to its original 
amount, or one-third of the maximum which it had just reached. 
In the fifth year, primary demand falls 10 per cent, and derived 
demand now falls to less than nothing; and so on. 

In order to make this example more realistic, two major facts 
must be allowed for: first, the time required to make equipment 
and, second, the limited capacity of the equipment-making 
industries. As a result of these forces, the productive activity 
in the equipment-making industry will follow a course like that 
of the lower dotted line, and the amount of equipment in use 
will behave approximately in the way shown by the upper dotted 
line. 

In terms of percentages, the theoretical need for equipment 
fluctuates twenty times as much as the widest range of fluctuation 
in the consumer’s ultimate demand, and even in terms of dollars 

1 Figured on the original amount as a base. 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


393 


it fluctuates twice as much. 1 The actual work of making 
equipment fluctuates by from six to seven times as large a 
percentage as consumers’ demand, and its downward swings, 
if not its upward ones, are absolutely greater in terms of dollars 
and cents. This clearly exhibits the intensification of fluctu¬ 
ations in derived demand. But the timing of the curves with 
relation to each other is even more significant. The theoretical 
need for construction of equipment is greatest, not when the 
demand for the ultimate product is greatest, but when it is 
growing fastest, considerably before it reaches its peak. As a 
result, the work of making equipment may lag considerably 
behind the need (as it naturally would do) and still it will natu¬ 
rally reach its highest point and start downward before the 
consumers’ demand does so. It will appear to lead, not because 
it really does lead, but because the thing it follows reaches its 
maximum and minimum points something like a full quarter- 
cycle ahead of the highest and lowest points of consumers’ 
demand. This hypothetical case, then, offers a rational and 
seemingly adequate explanation of the fact that the capital¬ 
making industries appear to take the lead in industrial fluctua¬ 
tions. 

One further point is also vital. An increase of one dollar 
in the demand for consumers’ goods produces, in time, an increase 
of two dollars in the output of equipment, so long as the makers 
of equipment are able to expand their production. It is safe 
to suppose that most of this two dollars is spent for consumable 
goods, and of this the manufacturers receive their share. If all 
industry is moving in the same direction, they also receive a 
share of the increases due to purchases of equipment by railroads, 
mines, etc. On the whole, it seems fair to assume that one 
dollar’s worth added to the output of consumable goods brings 
back another dollar to add to it, and that the two may bring 
back two more, and so on, as long as the capital-making industries 

1 The need for equipment ranges from 300 per cent of its original amount to 
— 100 per cent, a total range of 400 per cent, while the primary demand ranges 
from 100 per cent to 120 per cent or 20 per cent actual change. This method of 
figuring errs on the conservative side, as it understates the real discrepancy between 
the two fluctuations. 


394 


ECONOMICS OF OVERHEAD COSTS 


still have capacity for expansion. When things have reached 
this limit, further growth of consumers’ demand is impossible, 
and this removes the need for additional equipment so that 
demand for equipment falls off, the producers of equipment have 
less money to spend and thus consumers’ demand falls off in turn. 
When the shrinkage in capital-production can go no farther, 
consumers’ demand also ceases to fall, which soon brings the 
demand for equipment up to its original level, and this in turn 
increases consumers’ demand, and a new cycle is ready to begin. 
This is a rough and impressionistic way of expressing it, but it 
seems to be essentially true. 

So much for pure hypothesis. In an actual case, the financial 
magnitudes wouid fluctuate more than the physical, since prices 
would rise with reviving business, and vice versa. Notwith¬ 
standing this compounding of forces, the physical facts remain. 
The writer has elsewhere studied the relation of railroad traffic 
to orders for cars, showing that orders for cars fluctuate far more 
than traffic, and that they are at their highest, not wdien traffic 
is largest, but when it is growing fastest. 1 For the present 
purpose it will be more w r orth while to examine the result of the 
orders for cars, in the form of cars added to the railroads’ equip¬ 
ment. The figures w r ould naturally not agree exactly, on account 
of retirements, and the actual delivery of the cars w r ould naturally 
lag behind the orders. 

The result is showm in Chart VIII. The net increase (or 
decrease) in cars follows the net increase (or decrease) in traffic, 
lagging by about a year and with decidedly less violent fluctua¬ 
tions. Nevertheless, it fluctuates several times as violently 
as railroad traffic itself, even after allowing for replacements and 
assuming them constant. As for the timing of the two curves, 
the yearly interval is too long to give a sensitive record of correla¬ 
tion, but the net increase of equipment has the appearance of 
taking the lead of traffic about as often as of following. The 
years 1917-19 are, of course, not normal. When one remembers 
that the work of making the cars comes between receiving the* 

1 See “Business Accelerations and the Law of Demand,” Journal of Political 
Economy (March, 1917), pp. 217-35. 


CHART VIII 


OVERHEAD COSTS AND TEIE BUSINESS CYCLE 


395 





jlM-f 


Util 




gTOf 




4Zj~Ti j~j~t 


iiltitnt 


i ri. I. i i i 


o o 

o *o 

<N M 





W 


^ ^ ^ 

o o o 

co M H 


fcS 

r\ 

A 

n 


VJ 

w 

yj 

CM 

U 

co 

u 

u 

10 


I I I I I 


o 


o 


Growth of freight traffic and of car capacity. Data from Chart I, chapter xiii, above 
















































































































































































































































































































































































































































































396 


ECONOMICS OF OVERHEAD COSTS 


orders and delivering the finished product, and therefore that its 
highest ranges would be spread between the points of greatest 
increase in traffic (which makes roads order cars) and the points 
of greatest increase in cars actually in service, it seems clear 
that the work of making cars fluctuates appreciably ahead of 
fluctuations in railroad traffic. On the whole, the figures appear 
to corroborate the theory, as far as they go. 

3. OTHER CAUSES 

Of course, all this presupposes an elastic credit system, so 
that industries can buy equipment without taking just that much 
money away from the people who would otherwise have spent it 
on consumption. The funds can be borrowed from banks, and 
the banks can furnish them without immediately taking them 
out of consumers’ purchasing power. If this were not possible, 
the spending of money on equipment would have no chance to 
return in the shape of a cumulative increase in consumers’ 
demand, and the self-reinforcing cycle would have no chance 
to get under way. An elastic credit system is the great enabling 
cause of all these movements. 

The undue concentration of capital expenditures ought to be 
relieved by the effect of high prices at the peak and low prices 
during a depression, which would make it worth while to buy 
equipment during depressions for the boom that is coming, and 
deter people from buying at the peak. But while fluctuating 
prices ought to work in this way, they do not. If anything, 
they seem to work in the other direction. People might like 
to buy at the bottom, but they do not know that they have 
reached bottom until they have not only reached it but passed 
it and are unmistakably starting up the other side. Then they 
begin to buy, and rising prices will rather spur them on than deter 
them, so long as they expect prices to go still higher, for they can 
more than get their money back from consumers—or so they 
reckon. And no one knows when the top is reached until it is 
past and the downward swing has begun. 

It is of the very essence of the business cycle that, while 
any intelligent business man knows enough to expect it, no one 
can know absolutely at what stage of the cycle he is on that 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


397 


particular day, nor in how many days the next stage will appear. 
That they do not know this is another reason why they so manage 
their several businesses as to bring on themselves the very thing 
they do not want—this, and the fact that they have learned to 
look for its coming with a fatalistic resignation. Some even 
derive considerable consolation from the chance to discipline 
labor in the harsh school of unemployment. 

And so we might go on, discussing the lagging rise of wages and 
interest, the effect of fixed contracts in a changing market, the 
overcapitalization of expected future earnings, the decrease of 
unit costs as output increases, followed by a somewhat unexpected 
increase as capacity is reached, and costs are swollen by overtime, 
green men are hired, laborers take things easy because they are 
sure of their jobs, and prices of materials and equipment rise 
faster than those of the finished product. 

This last phenomenon clearly has a close connection with 
overhead costs. When demand is strong and increasing, compe¬ 
tition between producers takes the shape, not of reducing the 
price of the finished product, but of offering more for the factors 
of production. This takes effect first and strongest on the prices 
of materials and equipment, while wages do not rise as much as 
prices, and interest rates are decidedly slow in rising. And 
because operating expenses do not increase as fast as output, it 
is possible to pay a higher premium for materials and equipment 
than is being received for the finished product, and still make a 
gain in profits. That is, it is possible so long as the point of 
increasing cost has not been reached. After this point is passed, 
the gain is turned into a loss, but many producers have committed 
themselves, by contract or by the installing of equipment, and 
find it difficult or impossible to draw back. One of the sources 
of danger in this whole situation is the producers’ lack of accurate 
knowledge as to where the economies of increased output come 
to an end. Better analysis of the real behavior of constant and 
variable expenses might save considerable losses. 

4. THE SHITTING AND CONVERSION OF OVERHEAD COSTS 

We have already seen how the underlying costs of production 
continually change their form as they are passed on from producer 


39$ 


ECONOMICS OF OVERHEAD COSTS 


to producer, generally being converted from constant costs into 
variable charges. The cattle-raiser takes care of the interest 
on his mortgage, the return on his equity in his farm, and the 
overhead costs of his own maintenance, all by selling his cattle 
for what they will bring per head; and the cost of live cattle 
becomes a variable cost to the packing house which buys them. 
Not only that, but it is so much larger than all the rest of their 
expenses put together that their own overhead becomes relatively 
insignificant. Packing-house labor translates its overhead costs 
of maintenance into a variable charge on the company, except 
so far as the wage system sets a minimum limit on weekly 
fluctuations of wages; and thus the financial expenses of packing¬ 
house products are almost all variable, though the basic economic 
costs are almost all constant. Be it remembered that we are 
speaking of the general rise and fall of business activity, and of 
the cost of working versus not working. The cost of doing one 
thing rather than something else is a different question and yields 
a different answer—provided there is something else to do. 

The price of the live steer is a joint cost, and is allocated 
somehow as between meat, hides, and other products, and the 
hides are then sold to a tanner, thus becoming entirely a variable 
cost to him. After he has added his quota of overhead, and of 
w r age costs which go to pay his labor’s overhead, he sells the 
leather to a maker of furniture, to whom the entire sum again 
becomes a variable cost. When the leather finally covers the 
seat of a chair and is sold, the purchaser pays so much per chair to 
cover all these overhead costs and the series comes to an end— 
unless the chair is an office chair, in which case it becomes an 
element in the overhead costs of the business which uses the 
office and there begins a new cycle of shifting and conversion. 

We have also seen how this shifting of costs distorts the 
economic reckoning when it comes to figuring whether it is 
economically worth while to produce goods or not. Every 
producer has an incentive to avoid idleness, but the strength 
of his incentive is measured by the amount of his own constant 
expenses, not by the total amount of constant costs involved in 
the whole process, from beginning to end of the chain of opera- 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


399 


tions and exchanges. And even this incentive is weakened in its 
action by the fact that if one producer devotes all his usual 
margin of profits to stimulating demand, his sacrifice will not make 
a large enough impression on the whole series of outlays to produce 
any decisive effect. 1 Furthermore, so far as his variable expenses 
are concerned, he has no incentive to expand, and every incentive 
to retrench; and these are usually the dominant part of his 
budget. When he retrenches, he saves the whole amount of his 
variable costs, though the producers to whom this money would 
go do not save anything remotely corresponding to his savings, 
and the community saves little or nothing. 

Return on investment is obviously a constant cost in such 
cases, and we have seen that the differential cost of labor at 
such times is negligible, so that labor is really a constant cost. 
The only item requiring further analysis here is the cost of 
materials. Since this includes, in principle, the cost of finished 
goods which a merchant buys to sell again, it is an item of enor¬ 
mous importance, embracing the costs of all previous processes 
until it includes almost all the expenses of industry by the time 
the goods are on the shelves of the retailer. So far as such things 
are perishable, the question settles itself: they must sell for 
what they will bring. But these perishables are chiefly raw 
foodstuffs and the business cycle does not center in such things; 
in fact, cyclical unemployment in agriculture appears to be 
slight. 2 

When durable materials are used, possible future uses are 
sacrificed. These future uses govern the present value of the 
material: the sum which is charged as a cost when the material 
is worked up. If the producer weighs costs and values correctly, 
he will put the materials in the form which will give them the 
greatest value, and at the time when they will gain the most 
value by being worked up. This refers, of course, to money 
values, but money values are the financial representatives of 
human needs. We are accustomed to think of prices as fulfilling 
this mission sufficiently well to place materials and energies 

*See discussion in chapter ii, section n, above. 

2 See King Employment, Hours and Earnings , pp. 36-46, 55. 


400 


ECONOMICS OF OVERHEAD COSTS 


where they do the most good, barring human ignorance and the 
inevitable distortion due to the fact that some are rich and some 
are poor. Where it is a case of present use against future, we 
are told that when speculators hold goods off the market because 
they expect to get a higher price later on, they are thus saving 
the goods until the time when the community will have the 
greatest need for them. And this is sometimes true in cases 
where the higher price does measure the greater need. But in 
the case of the business cycle the time of high prices is not the 
time of greatest need; it is the time of least urgent need, and 
greatest prosperity. There are not only rich and poor individuals 
in the community, but rich and poor periods. And the rich 
periods tend to outbid the poor ones for the general stock of 
materials, diverting them from the times of greatest need to those 
of greatest plenty. 

This proposition may be stated in more general terms. When 
the purchasing power of money itself changes, it loses its value 
as a guide to the most effective use of society’s stock of resources. 
In terms of need, the higher price does not represent the more 
pressing want; and if it outbids the lower price in the market, 
the economic system is to just that extent distorted. 

Of course it is the retailer who actually supplies the consumers’ 
needs, and it might seem that he is the logical person at whom to 
preach. The immediate destination of manufactured goods is 
always the warehouse, and the volume manufactured in a given 
week has little to do with the ability of dealers to supply the 
demands which may come in during that week. If the merchant 
moves the goods off his shelves, the manufacturer will fill their 
places. This view, however, puts the cart before the horse. 
The merchants’ purchases fall off more than their sales, and it 
is this discrepancy, and others like it, which explain the greater 
part of the falling-off of demand for goods at the factory. And 
one of the chief virtues of the policy of “working to stock” 
is that it is the most available way to keep goods moving out of 
stock, into the hands of the consumers, by seeing to it that the 
consumers have pay checks to spend. The penalty for failing 
to maintain a steady flow of goods into the warehouses is a 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


401 


clogging of the outlet for the goods already there, and a shrinkage 
of their effectiveness in satisfying wants. Anything which 
makes goods move along more steadily, even in the early stages 
of production, is to be credited with helping toward a much- 
needed smoothing of the flow of goods into the hands of the 
ultimate consumer. 

This policy of working to stock, then, is altogether good as far 
as it goes. It is of very great value in tiding over the low spots 
in the regular and fairly predictable seasonal cycles of demand. 
But the longer and less predictable hollows of the business 
cycle are harder to meet in this fashion. At such times, not 
as much use is made of this device as the health of industry 
requires. 

To sum up: materials and unsold goods constitute a “variable 
cost” of production, but the market distorts its amount. As 
a means of distributing production and consumption over the 
various phases of the business cycle, money values operate in 
exactly the wrong direction and are directly opposed to the most 
efficient timing of productive activity. When a depression has 
paralyzed industry and crippled demand, the value of materials 
is greater for present working-up and sale than the market 
shows, while the value of holding them for future use is less 
than the market indicates. Thus social accounting would 
always either discount the “variable cost” of working up mate¬ 
rials in time of depression, or put a premium on the value of 
resulting products, above the price the market offers. When a 
particular commodity is scarce, a high price checks its use and 
saves the supply against a future need which may be greater 
than the present. When the necessities of life in general are 
scarce, as may sometimes happen, a high price serves the same 
purpose, and speculators also further it by holding goods off 
the market and releasing them later when the need is still greater. 
It is an expensive and not altogether a just method of performing 
this function, but it does perform it after a fashion. But when 
prices are high because of prosperity, or low because of depression, 
their regulating effect is reversed and tends to aggravate the 
disease instead of curing it. 


402 


ECONOMICS OF OVERHEAD COSTS 


It may help to realize the effect of all this transforming of 
burdens in the process of shifting them, if we conceive of an 
industrial organization in which there would be no such shifting. 
If all industry were integrated and owned by the workers, what 
would be the relation of constant to variable expenses? Labor 
would then be in the position which capital now holds, and while 
the need of incentives to call forth extra effort or to compensate for 
long hours might make some wage system necessary, it would 
be clear to the worker-owners that the real cost of labor could 
not be materially reduced by unemployment. Since this is 
obviously true of capital, there would be little left save the 
depletion of natural resources which could fairly be charged as 
a variable cost of maintaining a moderate rate of production, when 
the alternative is unemployment. Partly finished goods would 
of course constitute a cost when devoted to further production. 
But for the purpose in hand, i.e., determining whether goods are 
worth the cost of producing them, rather than letting industry 
stand idle, the amount at which to reckon this cost is the differ¬ 
ential cost of reproducing these partly finished goods. And 
under the given conditions, this cost would include substantially 
nothing for labor and nothing for capital. Even the extra 
wear and tear on the physical equipment would count for next 
to nothing, so far as it could be made good out of the spare 
capacity of the repair force, using time which would otherwise 
be idle. 

“Idleness” on the part of common labor here means doing 
less work than the normal amount which is good for the worker, 
when the worker’s share of the product is not beyond the require¬ 
ments of adequate maintenance. For higher and better-paid 
grades of work, idleness would mean doing less work than one 
could do without thereby materially trenching upon the oppor¬ 
tunities of leisure which one’s income makes possible. Other 
ways of drawing the line might be more appropriate for special 
grades of work, or special types of temperament. But while 
the exact line might not be easy to locate with incontrovertible 
precision, nevertheless it could be drawn in a rough way, and 
there could not be the slightest doubt how to classify the kind 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


403 


of idleness which prevails during a typical business depression. 
It belongs under the heading: “Wasted capacity and unabsorbed 
burden of human overhead.” 

This imaginary integration of all industry has something more 
than a mere fictitious existence. It represents the underlying 
facts about the actual industrial organism, which is an integrated 
whole, whether its formal organization is cast in that mold or not. 
Nowadays the more far-seeing business men have caught a 
great deal of the feeling of their own dependence on the state 
of this greater organism, and of its dependence on the way in 
which their private business is conducted. This interdependence 
makes the social organism a reality, whether people recognize it 
or not, but the dawning consciousness of it makes it to some 
extent an active reality in its own right rather than a mere 
passive by-product of individual profit-seeking, at the mercy 
of the limitations of the money measure of human values. It 
means more than can be easily estimated when business men 
judge policies according as they are not “good social cost- 
keeping.” It means that the thing this phrase stands for is, 
in its rudiments at least, already a reality and not a mere dream. 

From this standpoint the integration of particular industries 
is a step in the direction of correct social accounting. It elimi¬ 
nates errors due to the buying and selling of materials, which 
convert the overhead costs of such materials into variable costs 
to the industry which uses them. But this does not go far 
enough. Labor would have to be included in the integration, and 
not stand wholly outside as a bargainer with something to sell, 
before the natural cost-keeping of the concern would approximate 
a true picture of the costs of the industry as a whole. 

5. STEADYING PRICES VERSUS STEADYING PRODUCTION 

One attempted remedy for the ills we have been studying is 
the steadying of business through steadying prices. This 
implies, of course, that the market is not in the grip of absolutely 
incontrollable competitive forces, but that someone is in a position 
to exercise some personal control over it. One large concern, 
like the United States Steel Corporation, can, within limits, 


404 


ECONOMICS OF OVERHEAD COSTS 


control the market, and associations of smaller producers are 
probably able to promulgate ideas of what is economically sound 
or ethical or good for the trade, with sufficient force behind 
them to set the character of competition. Among the local 
merchants of a small town, there is no need of formal agreements 
to let the members of the trade know what will be considered 
fair rivalry and what will be resented as bad for the trade. 
Any industry which has heavy investment exposed to the danger 
of cut-throat competition is bound in time to develop adaptive 
reactions, and any industry which can protect itself against 
this danger must have some control over the lengths to which 
price-cutting goes during depressions. 

Steadying industry by steadying prices is an economic 

paradox, since a lowering of prices is supposed to be the way to 

revive a failing demand. The expression may, of course, simply 

mean steadying dividends without regard to output, and this 

may be what is usually meant; nevertheless it has been seriously 

argued that the way to steady the actual volume of production 

is by steadying prices. The crux of the case lies in the claim 

that when prices start down, people are slower than ever to buy, 

because the longer they w T ait, the more money they save, and 

* 

hence they wait for the market to reach bottom. Therefore, 
runs the argument, why would it not be equally effective and 
far less painful to bring the bottom up to the market and let 
prices strike bottom before they go below a normal level? If 
people are satisfied that prices are not going lower, they will 
begin to buy, not very fast, perhaps, but enough to prevent 
absolute stagnation. 

The point is well taken; buyers do hold off when prices are 
going down; the fluctuations of demand are intensified by this 
speculative element in the market, and the natural cure for 
slack demand may temporarily make the disease worse. Never¬ 
theless, if prices are ever to reach bottom they must get there 
somehow, and unless there is a bottom which is substantially 
below the top, there can never be the revival of demand that 
comes from the feeling that whoever buys now gets a bargain. 
The steadying of prices may prevent fluctuations of demand from 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


405 


being temporarily aggravated by the remedy employed, but 
instead it leaves them without any remedy at all. 

A stronger argument is that by protecting the company’s 
income, it can have money to spend on equipment and materials 
ahead of present needs, and so help to steady production in the 
industries. If all managers saw the light so strongly that they 
would spend all the funds they could lay their hands on in advance 
of immediate needs and without even getting their materials and 
equipment any cheaper than if they had waited , then—why, then 
we should be able to prevent the evils of the business cycle no 
matter what happened to prices. But, humanly speaking, it is 
natural to suppose that managers would be more ready to support 
demand in this vay if there were some material inducement in 
the way of a baigain price. 

Thus one might divide industries into two groups: one 
consisting of those nearest the consumer and the other of the 
producers of equipment and materials. The most important 
thing for the first group to do is to protect its income so that it 
may keep up its purchases and so, indirectly, protect the demand 
for its own products. And the most important thing for the 
second group to do is to give the first group a real motive to buy 

c’ 

in dull times. Thus the steadying of prices would be largely 
limited to the industries nearest the consumer. To be sure, 
the consumer is not the kind of buyer who is much governed by 
speculative considerations and who holds off when prices start 
down, waiting for them to reach bottom; hence the chief 
argument for steadying prices would not apply to him. But 
when prices to the consumer fluctuate, wholesale prices fluctuate 
in sympathy. And wholesalers and retailers tend to let their 
stocks run low when prices are falling, and replenish them rapidly 
when they have struck bottom (thus starting them upward again). 
To avoid all this, there might be a certain advantage in steady¬ 
ing prices to the consumer, who in any case gets less reduction 
than anyone else when a depression brings prices downward; 
provided always that the industries which benefited could be 
counted on to treat the resulting earnings as a trust fund for the 
purpose of supporting the demand for their means of production, 


406 


ECONOMICS OF OVERHEAD COSTS 


and thus indirectly supporting the demand for their own finished 
products by keeping labor at work and in receipt of pay. But 
in order to furnish an incentive to support the market, prices of 
producers’ goods must come down. Complete stabilization of 
prices to the consumer is at best of doubtful wisdom, but stabili¬ 
zation of producers’ prices is certainly a mistake. 

Thus it appears that when the United States Steel Corporation 
undertook to steady prices, they were starting at the wrong point 
in the industrial chain. As we have seen in the earlier part 
of this chapter, under perfectly steady prices there would still he 
great booms and depressions in the capital-making industries , and 
resulting booms and depressions in industry at large. There are 
forces at work which translate all fluctuations of consumers’ 
demand into greatly intensified fluctuations in the demand for 
the means, of production, and these react back upon the demand 
for consumers’ goods, so that the greatest fluctuations here are 
not original, but derived, and result from fluctuations of employ¬ 
ment in other industries. Thus steady prices will always mean 
violently unsteady demand in the capital-making industries, 
and these will affect the rest. The only remedy for this is to 
induce people to spend money in the dull times for equipment 
which they do not immediately need, and for materials to work 
up “ to stock.” A moderate reduction of prices would be a small 
sacrifice to make if thereby stabilization of output w^ere made 
possible. 

Such reductions must be kept within bounds, or the cure 
will be as bad as the disease. They must not bankrupt the 
industry, and this means not only the employing company but 
the whole body of producers it represents. If the company 
could save its own financial integrity by passing the loss on to 
labor in the shape of a reduction of wages, it would still remain 
true that if the buying power of the laborers is seriously crippled, 
other industries will suffer. “Buying power depends upon both 
price and output, and a collapse of either—at the farm or in the 
factory—causes a breakdown in the exchange of goods.” 1 

X W. W. Stewart, American Economic Review Supplement (March, 1922), 
p. 42. 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


407 


But how avoid the difficulty already raised; that when prices 
start down, the immediate effect is to check demand rather than 
to stimulate it? There is no way of conjuring this obstacle 
out of existence, but when manufacturers are buying materials 
to keep their factories going and avoid a shutdown, they will 
not always hold off for a small reduction in price. The best 
results would follow from a market in which prices, when they fall, 
fall quickly to a new and fairly stable level. If the power which 
producers have over the market could be used to bring about this 
kind of behavior, it would be far more useful than indiscriminate 
stabilization. 

As for the ultimate consumer, the chief fluctuations in his 
demand are the fluctuations of the pay envelope, and the way 
to stabilize his demand for goods is to stabilize production in all 
departments of industry. Whatever price policy promotes this 
end will be the best prescription for stabilizing the consumer’s 
demand for goods. It was once said of specie payment: “The 
way to resume is to resume.” And it begins to appear that the 
way to steady production is to steady production. 

6. REMEDIES FOR THE BUSINESS CYCLE 

The remedies for this series of evils are dictated by the causes 
at work. The relieving of destitution is necessary, but it is not a 
cure for the disease from which waves of destitution arise. It 
treats a symptom, rather than the root of the trouble. Since 
causes at work are manifold and act jointly, the remedies must 
reach into various fields. Physical production, the mechanism 
of prices and the credit organism must all be attacked, while a 
prerequisite to a successful campaign is a development of the 
business state of mind into a hopeful, constructive, and 
co-operative attitude. In proportion as tangible experiments 
show hopeful results, this state of mind will grow and consolidate 
itself until ultimately even the psychological elements in the 
business cycle may come under some measure of control. The 
agencies to which we must look include government, the banking 
system, insurance, industry itself, and organized labor. The 
tactics to be adopted are some of them aimed at whittling off 


408 


ECONOMICS OF OVERHEAD COSTS 


the peak of the boom, where it rises to altitudes at which business 
life cannot be sustained, others at filling in the bottom of the 
depression, and others at relieving distress whenever it occurs . 1 

Proposals for whittling down the summit of the boom are 
chiefly confined to the purely financial inflation which occurs 
after production has reached its limit and the only effect of further 
expansion is to raise the prices of goods and securities, rates of 
discount, etc. Since this is a financial matter, the remedy is 
financial, and consists in restricting the granting of credit by 
banks through pressure exerted by the Federal Reserve System. 
The most obvious form of pressure would be an increase in the 
discount rates, though the gamut of possible devices is a matter 
to be discussed by specialists and developed by experiment. 
The time for applying these checks would have to be determined 
by means of accurate and comprehensive business statistics— 
business barometrics which afford separate records of physical 
production and its financial dimensions. 

It will be noted that this remedy does not propose to cut 
down physical production, even at the peak. Yet there is strong 
reason for believing that industry actually outgrows itself in 
terms of physical output, and that part of the growth is unassimil- 
able and does not contribute to the long-run wealth of the 
country. So far as production consists of catching up with 
past undermaintenance and making five years’ quota of new 
equipment in one or two years, it plainly cannot last at that 
rate if directed at those objects alone. And so far as it further 
consists in making more goods for the producers of this equipment 
to spend their increased incomes on, this also cannot last and 
would do more good it distributed rather than concentrated in 
boom years. 

Imagine a man who owns a farm, a wood lot, a coal pit, and 
an iron mine, and runs a self-sufficing establishment, spinning, 
weaving, and making all necessary tools and utensils. He hires 

1 For a conspectus of proposed remedies, see paper by W. C. Mitchell on 
“Controlling Business Cycles,” and discussion: American Economic Review (March, 
1922), pp. 20-43. Also the American Labor Legislation Review (March, 1923), 
which is mainly devoted to this subject, and the same magazine for March, 1922, 
which contains a valuable bibliography. 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


409 


his laborers and sells them the goods they use, and produces 
whatever shows a profit. He finds that his establishment has 
times of great activity and other times when there is not work 
enough for all, and when idle hands are coming to him for support, 
or otherwise making nuisances of themselves. On examination 
it turns out that during the busy times he is making more looms, 
more threshing machines, more wagons, etc., so fast that if he 
kept on he would have more than he could possibly use. And 
he is also making more clothes, building larger dwelling-houses, 
and furnishing comforts and recreation because the additional 
money he pays out in wages is coming back in the form of 
increased demand for all these goods. And this cannot last 
any longer than the source from which it flows. A man in such 
a position would be perfectly clear that he could not always be 
doubling his supply of threshing machines in two years, and when 
he found how much trouble it made to let the workers who were 
dependent on this kind of work work themselves out of a job in 
the active period, he would probably begin scheduling this work 
so that he would get it done at a fairly regular rate. This would 
cut down the feverish activity which used to affect his whole 
force, but they would get just as much work done in the end. 
In fact, they would get more, because some of the workers in 
the most unsteady trades would prove to be unnecessary and 
would find their way into some steadier occupation. 

This is a tolerably true picture of some of the central features 
of the business cycle. When the manager of this enterprise 
started scheduling his work, he would probably begin by keeping 
the work going through a dull period, and making things in 
advance of his requirements. Then when demand revived, he 
could meet it without speeding up any part of his establishment 
to a pace which it could not maintain, or putting a demand upon it 
which he could not maintain. He would start by filling up the 
hollow rather than by cutting down the peak, though the effect 
might be similar in the end. 

One policy tending to reduce the peak somewhat is that of 
making the employer bear some responsibility for the overhead 
cost of casual labor which he may hire, thus tending to make 


4io 


ECONOMICS OF OVERHEAD COSTS 


him reluctant to handle his peak demand in this way until he 
has tried his best to take care of it with the labor to which he 
gives regular employment. This would also tend to make him 
anticipate its demands as far as possible, and to postpone the 
least essential parts of the work which he has not been able to 
anticipate. One further argument for filling up the bottom of 
the depression rather than cutting down the peak is that it is 
easier to agree when a depression exists than when prosperity 
has passed the safe limit and needs to be curbed. 

For filling up the hollows, the most positive and definite 
prescription is that government should plan an elastic schedule 
for public works of a postponable sort, and should save certain 
works to be prosecuted only in time of depression and unemploy¬ 
ment, or prosecute the entire program more actively at such 
times. There is no need to argue the merit of this plan, for it 
is self-evident, especially after what has been said as to the causes 
of booms and depressions. It goes to the root of the matter, 
and the only debatable questions are those of w r ays and means for 
carrying it into effect. It has also been suggested that this same 
principle could be applied to the purchase of the more standard¬ 
ized sorts of supplies, if funds were available to buy them ahead 
of the need. 

Of course these elastic budgets must be financed, and the 
revenues of governments shrink somewhat in dull times, especially 
those which come from indirect taxation. But between the set¬ 
ting aside of funds in good time and the use of banking credit, the 
thing could be done without any serious difficulty. In Germany 
since the war, governments have financed the employment of 
hundreds of thousands of workers engaged in building roads, 
making gardens, reclaiming moorlands, completing the Berlin 
subway, building and repairing houses, and in many other kinds 
of work of general usefulness. Much of this labor works for 
private employers and contractors, with some necessary measure 
of public oversight . 1 And if Germany can bear the financial 
burden, richer countries can certainly do so. 

1 See “Productive Unemployment in Germany,” Survey (December 24, 1921), 

pp. 463-65* 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


411 

Still more could be accomplished if the resources of private 
industry itself were enlisted in the same cause, and this will be 
done as fast as private industry comes to feel and to bear, toward 
the joint overhead costs of the industrial organism, responsibility 
commensurate with its powers and opportunities. Railroads, 
for example, could do more in this direction than any other 
single agency, if they definitely undertook the task and had funds 
to carry it out. In the words of one writer: “The fact is that the 
state and the nation cannot get a grip of any kind on the unem¬ 
ployment problem until the capitalist has first discharged his 
obligations and responsibilities in the premises. When that is 
done the residual problem for federal or state action will not be a 
serious one in a rapidly expanding civilization like ours .” 1 
Systems of unemployment compensation are included in this 
program as means of making it worth the employer’s while to 
stabilize work in his own establishment. 

It has also been suggested that this common peril of depres¬ 
sions would require some common organization to meet it, and to 
exercise control of the strategy of business as a collective organ¬ 
ism, in somewhat the way in which the Federal Reserve System 
controls the grand strategy of banking, while leaving each bank 
to manage its more strictly private affairs . 2 If prediction in 
social matters is ever justified, it is worth hazarding the prophecy 
that some day such a vehicle of economic statesmanship will be a 
reality, though from the present perspective its form and jurisdic¬ 
tion can only be conjectured. With such an organization in 
existence, social cost-keeping would gain a definiteness which 
is hardly possible today. 

The most probable first task of such an organization grows 
out of unemployment insurance, which bids fair before long to 
become a recognized part of our economic machinery. Such 
insurance should, so far as possible, give every employer a 
chance to lower his rate of premiums by improving the regularity 

^ohn Calder, “How the Employer Can Safeguard a Man’s Job,” Survey 
(October 15, 1922), p. 95. 

3 See W. W. Stewart, discussion in American Economic Review Supplement 
(March 1922), pp. 42-43. 


412 


ECONOMICS OF OVERHEAD COSTS 


of employment in his own establishment. If it does not do 
this, employers as a whole will still have a collective interest in 
reducing their burdens, and a collective organization will be 
the natural means of making this interest effective. Even if 
the employer’s individual interest is directly enlisted, guidance 
and co-ordination will still be vitally needed, and these needs will 
justify a collective organization. With this in existence and with 
labor given some effective degree of partnership in individual 
enterprises, we shall perhaps be on our way to the development 
of a federated economic state which may take over some of the 
burdens of economic control which now rest over-heavily on the 
shoulders of our somewhat ill-adapted political organization. 
But that is too large a prophecy to enter on at this time, and far 
transcends the limits of a study of overhead costs. 

Other auxiliary measures include a better co-ordination of 
employment offices, and better statistical indexes of business 
conditions. Business is moving in the direcexon of funding its 
stock of private knowledge and so making the “intellectual 
overhead” far more effective than at present. Another project 
is the stabilization of the dollar, so ably and indefatigably 
advocated by Irving Fisher. From what has already been said 
it appears that absolute stabilization is not desirable; that there 
should be some room for the prices of producers’ goods to fall, 
and so give industry and government an incentive to buy and 
build ahead of demand, in dull times, without compelling the 
prices of other things to rise enough to maintain a fixed average. 
However, the longer swings of prices do nothing but harm, and 
the plan proposed by Professor Fisher could be so adjusted as to 
counteract these longer swings without being so quick and strong 
in its action as to prevent minor ups and downs which might 
perform a useful function. Indeed, it might not prove practicable 
to prevent these minor and temporary swings of particular groups 
of prices from producing their natural effect upon the average 
level. 

One of the things most needed in order to cure the business 
cycle is confidence that it can be cured, just as one of the things 
most vital to maintaining banking solvency is confidence that 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


413 


it can be maintained. Such confidence can only come as the 
result of successful measures of a more tangible sort, which means 
that the effect of such measures will be cumulative; they will 
progressively diminish the resistance they have to meet and their 
first task will be the hardest. And it will not be necessary for 
government or other curative agencies to find or furnish work 
for all the four million and more whom depression throws out 
of work. If part of them are employed, these will employ others 
to make goods for them, and these in turn others. The saving 
grace of this chain of cumulative disturbance is that it will work 
cumulatively in both directions. But for this, the task might 
well appear hopeless. As it is, the only conclusion to which an 
unbiased mind can come is that it is economically possible to cure 
the worst evils of the business cycle, and that a correct compre¬ 
hension of the character of social overhead costs will play a 
large part in the remedies which should effect this cure. 

7. REACTIONS AND CONSEQUENCES 

If production is regularized, there will be a great release of 
productive energy which now goes to waste, and if this were to 
happen quickly, there would arise a serious question how we 
should use our new power, and what realignments of production 
we should have to make in order to keep a proper balance between 
extractive industries furnishing raw foodstuffs and materials, 
steel-making, machine-making, and other capital-making indus¬ 
tries, and the making of goods for consumption. One saving 
feature is the fact that the fundamental metal-working equipment 
is fairly adaptable, and can be used, with some alterations and 
adjustments, to produce new kinds of tools and machines. 
One typical example of the kind of outlet available for released 
energy might lie in keeping the world’s supply of petroleum up 
to the incredibly growing demands of transportation for gasoline 
and fuel oil. There might, however, easily come to be an over¬ 
supply of some kinds of productive equipment. 

One remedy for this would be, instead of multiplying the 
supply of the same kinds of machines now in use, to put capital 
into more refined forms, so that each laborer would have better 


414 


ECONOMICS OF OVERHEAD COSTS 


equipment to work with. This is the kind of adjustment in the 
“proportion of factors” which is inevitably required to absorb 
a supply of capital which increases faster than the working 
population. Such an adjustment means a reduction in the 
productive value of the capital, and investments in this form 
could not pay the customary rate of interest on the present cost 
of equipment. But either a reduction in the price of equipment, 
or of interest rates, or both, would make a substantial growth of 
such labor-saving investments economically practicable. 

One trouble with the economic system lies in the unimagina¬ 
tive way it has of sticking to the kind of investments which are 
customary and multiplying the number of machines, when it is 
open to question whether there is labor enough to work them 
all to capacity and to feed them with materials over a term of 
years. Such investments promise the usual yield, but often 
they become superfluous as soon as the boom has died down— 
the boom of which they were themselves partly the cause. Then 
they yield nothing, and may yield less than nothing from the 
community point of view, by dividing the labor supply up 
among too many plant units, none of which is working at effective 
capacity. This wastes labor and produces an unnecessary 
duplication of indirect expenses. 

On the other hand, the same amount of capital put into new 
forms of machinery which would give $1,200 worth of equipment 
to the same laborers who now work with $1,000 worth, might 
yield a low but permanent return. If the makers of machines 
sold the $1,200 worth of equipment for $1,000, or even $1,100, 
for the sake of maintaining production through dull times, and 
if the banks would lend capital at low rates for such purposes, 
the combined effect might bring a considerable volume of such 
equipment into the realm of worth-while investments. There 
is some reason for thinking that the customary interest rate is 
higher than the marginal productive worth of capital justifies, 
measuring it by the amount of funds the investors and the credit 
mechanism are able to furnish, or by the amount of capital 
appliances which the industries devoted to that purpose are 
capable of turning out. But that is a trail which would lead 


OVERHEAD COSTS AND THE BUSINESS CYCLE 


415 


us far afield. In any case, where investments are being made to 
keep industry moving rather than out of an urgent pressure for 
profits, there should be more willingness to put capital into these 
conservative forms which will yield their return in lowered 
operating expenses on the existing output, rather than in multiply¬ 
ing output, to the quick glutting of the markets. 

8 . CONCLUSION 

The business cycle is one of the most many-sided of economic 
questions, and this discussion, brief and inadequate as it is, and 
devoted mainly to matters of overhead costs, has nevertheless 
covered such a wide territory that a simple summary is well nigh 
out of the question. We have seen that the dependence of 
profits on sales, and the timing of capital expenditures, are two 
facts of the first magnitude as causes of our uncontrolled fits 
of alternate energy and paralysis. We have seen that private 
financial accounting distorts the relative amounts of constant 
and variable costs in industry, making it seem that most of them 
are variable when in fact, with reference to this problem, most 
of them are constant. We have seen that a sense of community 
accounting and its significance is dawning, and that it is in direct 
conflict with the short-sighted policy of stabilizing prices, 
protecting the earnings of capital (the only overhead which 
old-fashioned accounting recognizes) and letting production fall 
off and the evils of unemployment accumulate. And we have 
seen that there is a list of remedial measures, financial and 
industrial, private and public, which offer a real hope of sub¬ 
stantially eliminating this, the greatest waste of “idle overhead” 
in modern industry. 


CHAPTER XX 

DISCRIMINATION IN THE MODERN MARKET 


SUMMARY 

The nature of the market, 416—Dumping, 420—Discrimination between 
localities, 423—Different classes of buyers, 425—Discrimination between com¬ 
modities, brands, and grades, 428—Discrimination according to service, accommo¬ 
dation, or time, 430—Makeweights in the bargain, 431—Conclusion, 432. 

I. THE NATURE OF THE MARKET 

If one had to choose a motto of six words, expressing the most 
central economic consequence of overhead cost, the first choice 
might fall upon some such phrase as : “Full utilization is worth 
its cost,” but a close second would be: “Discrimination is the 
secret of efficiency.” This last, to be sure, needs to be taken with 
a proviso: one must know where to stop. The economic basis 
of it is simple. Existing business may or may not cover all 
overhead costs, but in either case, if there is spare capacity, 
added business will cause no added overhead, and will be a gain 
at anything above differential cost, so long as it can be kept 
separate from existing business, so that existing earnings are not 
impaired. This leads to a system of making each separate 
section of the business pay the largest possible yield above 
differential cost. A “section of the business” may mean a 
single customer or a single sale, but, in general, classification 
is limited by the extent to which business convenience makes it 
practicable, or public sentiment makes it prudent. 

For discrimination is not solely an economic fact. It raises 
moral and social issues: it is the tool of favoritism and greed and 
the vehicle of the highest social justice. It may rouse our righteous 
resentment or our admiring commendation. So far as overhead 
costs are concerned, the role they play is passive; they permit 
discrimination: the pursuit of maximum profit impels men to 
discriminate, and most of the other motives known to man 
join in at one time or another, playing a part and modifying the 
character of the result. 


416 





DISCRIMINATION IN THE MODERN MARKET 


417 


Economists are accustomed to assume that under competition 
there can be but one price at one time in one market. This 
assumption is partly the result of observation, for markets do 
show a tendency to iron out inequalities in prices, and partly an 
a priori premise, growing out of the fact that the economist’s 
study of the laws of price has been cast in the mold of a search 
for the natural level of prices; thus assuming that there is some 
natural level toward which the different prices in a market 
gravitate. We have recently witnessed an interesting practical 
commentary on this assumption, when the Federal Trade 
Commission, attempting to prove that restraint of trade exists 
in the meat-packing industry, cited as evidence the fact that the 
different packing-houses all pay the same prices for live cattle, 
and the representatives of the packers replied that this is the 
traditional symptom of a perfectly competitive market and only 
goes to prove how keen the competition in these markets is. 
Both sides, it may be remarked, employ professional economists. 
Which is right ? 

Without attempting to prejudge this particular issue, on the 
general question the truth appears to be that the regular operation 
of a competitive market implies that some take the lead and 
others follow, and unless there is an appreciable interval during 
which prices differ it is difficult or impossible for those who take 
the lead to gain any advantage by the typical competitive 
tactics of raising their prices for things they wish to buy, or 
lowering them on things they wish to sell. The gain consists 
typically in selling more goods at the lower price. This is some¬ 
thing a monopoly could also do, but competing concerns are sup¬ 
posed to have more of an incentive to cut prices than monopolies 
have. If all the competitors followed suit instantly the moment 
any cut was made, each would gain his quota of the resulting 
increase in output, and no one would gain any larger proportion 
of his previous business than a monopoly would gain by a similar 
cut in prices. Thus the competitive cutting of prices would natu¬ 
rally stop exactly where it would if there were no competition. 

The distinctively competitive type of gain comes from getting 
more than one’s former quota of the business: getting all the 


418 


ECONOMICS OF OVERHEAD COSTS 


new business which the reduced price brings forth, or getting 
business away from one’s competitors. This gain takes place 
chiefly in the interval after the customers know of the reduction 
of prices and before they become aware that competitors have 
followed suit. This rests on a further condition, namely, that 
it takes an appreciable time for the customers to transfer their 
trade. If they all moved at once, the first competitor would 
have all the trade, provided he could handle it, leaving nothing 
for the others. 

Often he does get all he can handle, and the others, for the 
time being, content themselves with what is left over. This 
is in cases where goods are standardized and “competition 
centers in price,” so that a slight differential is decisive. More 
often, however, there are questions of quality to be considered 
and many customers keep on buying the brands to which they 
are accustomed, so that the effect of a reduction of price by one 
competitor is cushioned and retarded. In a sense each compet¬ 
itor has a monopoly of the difference in quality (real or supposed) 
between his goods and his rivals’, and this qualified monopoly 
is a feature of the typical “competitive” market. This gives 
the trade time to observe how serious are the inroads which the 
initial cutter of prices succeeds in making, and to decide whether 
it is necessary to follow suit. And this interval gives the initiator 
of the movement his chance to enlarge his business and make 
what may be a permanent gain, provided he has not overreached 
himself and set prices lower than his costs will justify. 

Thus the retarded action of the market which permits 
different prices to prevail at the same time is not really an 
“imperfection,” as theoretical economics has been inclined to 
regard it. On the contrary, it is an essential requirement, 
without which it could not produce its characteristic effects. 
It means that, to a limited extent, each producer has his 
own individual market, connected more or less closely with 
those of his competitors, so that discrepancies are limited in 
amount and in duration, becoming narrower and briefer in 
proportion to the standardized character of the goods. 

Large-scale manufacturing adds further structural complexity 
to the market, for it means that a single concern sells goods in 


DISCRIMINATION IN THE MODERN MARKET 


419 


nation-wide markets. A nation-wide market is really a system 
of markets so connected by railroads and telegraph wires that 
prices of standardized goods cannot differ for long by more than 
the cost of transportation, plus enough margin to pay for the 
trouble of a simple shipment and sale. Some markets of this 
kind show such a systematic organization that it is virtually 
possible to tell what the price is in any part, if one knows the 
price in some other central part, and also the costs of transporta¬ 
tion. Thus it is customary to say that Liverpool is the world’s 
wheat market, and that prices elsewhere are governed by the 
Liverpool price plus or minus the costs of transportation, accord¬ 
ing as the place is one which sends wheat to Liverpool, or receives 
it from that center. This regularity is the natural result of 
unfettered trading, not of any direct policy of men. 

But markets for manufactured goods are not naturally so 
systematic. Suppose that three large manufacturing concerns, 
in widely separated places and with different costs of production, 
are competing for a nation-wide market. The situation is a 
trifle like Argentina, Canada, and Australia furnishing the world- 
market with wheat, but there are some important differences. 
In the first place there is no home competition for the manu¬ 
facturer in his own district, only the distant competition of a 
rival shipping from another region. Hence he can, if he chooses, 
keep his price higher in his own town than in neutral territory 
by adding the cost of transportation his rival would have to pay, 
instead of making it lower by subtracting the freight he is saved 
from paying himself. In the second place, there is not the semi¬ 
automatic adjustment which exists in agriculture, whereby if 
one region can raise wheat at a low cost of labor and other 
elements, cultivation is intensified until diminishing returns set 
in and the marginal cost roughly adjusts itself to the price, while 
land rents absorb the surplus and convert it into a cost of produc¬ 
tion. In manufacturing, each establishment has its cost and its 
profits and there is no margin at which they all become equal 
and no landowner to capitalize the profits of the more efficient 
concerns and call them his. 

Under such conditions, the natural price in any one part of 
the market will be hard to determine. Goods from each center 


420 


ECONOMICS OF OVERHEAD COSTS 


of production can be laid down there, at cost of production plus 
transportation, and the price will generally be high enough to 
let in all three producers, giving the most favored one a profit. 
Add to this the fact that all of them have overhead costs, so that 
cost per unit falls as output increases, and the price situation 
becomes thoroughly indeterminate. Each producer can afford 
to enter his rival’s territory and sell an additional lot of goods 
there for less than he can afford to take as an average on his 
whole output, and the result cannot be foretold by calculating 
what each would do if he were an “economic man.” 

2 . DUMPING 1 

Where distances are short and costs of transport low, discrimi¬ 
nation is kept within narrow limits, because anyone in the 
favored market can buy the goods cheap and ship them into the 
markets where they are dear. It is only the very distant con¬ 
sumers, generally in foreign countries, who, just because it 
costs so much to get the goods to them, can get them very much 
cheaper than people who live near the factory. This is, of course, 
an inverted way of putting the case. The goods are not sold 
cheaper because of the freight they have paid, but they can be 
sold cheaper if the producer wants to, without coming back and 
spoiling his home market, because of the freight (and duties) 
they would have to pay to make the return journey. Which 
comes to much the same as saying that the freight on the foreign¬ 
er’s goods is subtracted from the price he pays instead of being 
added. 

When the foreign consumer pays an absolutely lower price 
than the home buyer, there can be no doubt that the business is 
either a monopoly abusing its power by exacting a heavy monop¬ 
oly profit, or else it is a business in which constant costs are 
decidedly heavy. The typical objections from the home con¬ 
sumer are that if the lower foreign price is profitable, the higher 
domestic price must be extortionate, and that the producer is 
keeping up the price at home by disposing of surplus goods 

1 For a fuller discussion of this subject, see Viner, Dumping : A Problem in 
International Trade. University of Chicago Press, 1923. 


DISCRIMINATION IN THE MODERN MARKET 


421 


abroad. To this the answer is made that the foreign sales yield 
something above differential cost, so that they relieve home sales 
of part of the burden of overhead costs, and that if the goods 
were not “dumped” abroad, the home price would have to be 
still higher, rather than lower, because the home market would 
have to bear all the overhead which now the foreigner helps to 
bear, even if he only helps a little. 

Where does the right of the argument lie? Before trying 
to decide, one thing must be noted which distinguishes businesses 
of large constant costs. Ordinarily it is thought that a monopoly, 
charging the price which yields the greatest profit, will make 
some profit above the cost of production. To some this proposi¬ 
tion seems absurdly self-evident. Nevertheless it is not true. 
The most profitable price is such a price that the margin above 
differential cost (not average cost), multiplied by volume of 
sales, will be a maximum. If the business has large constant 
or residual costs it may not be able to cover them, do what it 
can. The “maximum monopoly profit” may fail to cover all 
the overhead outlays. Not that such a case is typical: it 
implies overinvestment such as a monopoly would not willingly 
be guilty of. Thus it is likely to occur only where the monopoly 
is one which has been formed to cure the ills of an unduly compet¬ 
itive trade, afflicted with too much producing capacity, or else 
where a plant has been built from other than purely commercial 
motives, such as the Panama Canal, or, possibly, the Virginian 
Railroad. In any case, where constant costs are large, monopoly 
price is likely to be quite near the level of competitive price) 
especially where the demand is decidedly elastic. The competing 
concerns themselves have to make a considerable margin above 
the differential cost of production in order to cover their legitimate 
overhead, so that the difference between the two cases may 
become quite slight. 

It also makes a difference whether the dumping is seasonal, 
intermittent, or a permanent policy. Any concern may have a 
seasonal surplus of capacity, and sales in foreign markets, 
especially in the Southern Hemisphere where the seasons are 
the reverse of ours, may be the most legitimate method of 


422 


ECONOMICS OF OVERHEAD COSTS 


regularizing output, keeping the organization together and 
preventing idle overhead of labor as well as capital. Where 
dumping is a permanent policy, the differential cost of the 
goods cannot be figured in quite the same way, for in the long 
run any such large section of output occasions overhead costs of 
its own and should be charged with them. If a plant has so 
much unused capacity that the growth of the home market, 
even over a period of years, will not absorb it, it must be a very 
large plant indeed, so large as to have some measure of dominance 
over the market. And if there are a number of smaller plants, 
all in the same condition, and each of them dumps its share of the 
surplus above what the home market will absorb, this argues a 
considerable degree of concerted action, since any one concern 
could always make more money by selling a little less abroad 
and a little more at home where the price is kept higher. To 
refrain from doing this implies acting in the interest of the group 
rather than for purely private profit, and this in turn implies 
that the home market is not entirely a competitive one. 

The best construction which can be put upon this situation is 
that there is surplus producing capacity in the industry, which 
would naturally result in a condition of “cut-throat competition” 
if competitive forces went absolutely unchecked, and that 
they are checked by a general sentiment against “spoiling the 
market,” which sets an informal sort of limit on the cutting of 
prices at home, that the larger concerns bear the chief burden of 
stabilizing home prices, with the result that they are not able 
to market as large a percentage of their capacity there as the 
smaller concerns, and that they make up for this by using the 
foreign market as a dumping ground, a resource for which the 
smaller concerns have not sufficient capital. In a situation 
such as this, the effect of dumping on domestic prices is very 
difficult to determine. 

If this outlet did not exist, the large concerns would find their 
tolerant attitude toward the smaller ones more expensive and 
the result might be fiercer competition. Or the fear of such a 
competition might serve as an argument to persuade the trade 
as a whole to abide by a higher level of prices, under which the 


DISCRIMINATION IN THE MODERN MARKET 


423 


larger concerns could do as well as before. The situation here 
described is an ambiguous one, neither strictly competitive nor 
strictly monopolistic, but it is precisely the kind of situation 
likely to result from the influence of overhead costs. If the home 
market were given over to unchecked competition or to absolute 
monopoly, it is difficult to see how the price could be materially 
affected by dumping, either for better or for worse. As it is, 
the answer is indeterminate, like so many of the answers to 
problems of price where overhead costs play a part. 

Another possibility is that the producers have power to 
exact the prices which would yield the maximum monopoly 
profit, but refrain from doing so out of charity, fear of public 
action, or some other motive. This idea is implied in much that 
is said on such topics, and might be called the “ ashamed-to- 
take-the-money” theory of value and distribution. 

From the point of view of the foreigner, the chief objection 
to dumping arises from the fact that the cheap supplies cannot 
be relied on forever. Otherwise producers and consumers alike 
could adjust themselves to the blessings which the legerdemain of 
cost-accounting conjures into their laps, and the nation would 
be richer by the use of goods whose overhead costs they are not 
required to pay. Where the goods which are dumped are raw 
materials, foreign producers may fatten their profits by using 
them, and perhaps sell the products back to the country from 
which the materials came. Producers who have to compete 
against dumping feel a grievance, especially as their markets are 
flooded at just the times when demand is weak and their efforts at 
stabilization are hampered. If the foreign country wishes to be 
self-sufficient it may be worth while for it to bear the immediate 
sacrifice involved in excluding goods which others wish to dump 
upon them. 

3. DISCRIMINATION BETWEEN LOCALITIES 

The principles of dumping apply also to domestic trade, but 
within narrower limits, since freight rates are lower and there are 
no customs tariffs to prevent cheap goods from returning to 
flood the protected markets. Within these limits, the geo- 


424 


ECONOMICS OF OVERHEAD COSTS 


graphical structure is capable of taking one form or another 
according to the policy of the larger concerns—witness the long¬ 
standing controversy over the system whereby the price of steel 
is fixed at the Pittsburgh price plus freight to destination, no 
matter where the steel is actually made. Here is a market 
based on a central point as the wheat market is based on Liver¬ 
pool, but it is a producing instead of a receiving point, and the 
structure is not dictated by any such inevitable competitive 
forces as those which shape the wheat market. Other typical 
structures include the sale of branded package goods at a uniform 
price to the consumer, disregarding costs of carriage, the meeting 
of local competition wherever it exists, and the differentials 
which exist between cheap and dear stores in cheap and dear 
retail districts. 

The chief abuse involved in local discrimination is its 
deliberate use by a monopolistic concern to stifle growing compe¬ 
tition. 1 This latter practice has apparently subsided into a 
weapon for disciplining the trade and keeping it in order: an 
intermittent warfare designed to penalize independent concerns 
who cut prices too low and so abuse the tolerance with which the 
larger concerns commonly treat them. This deters them from 
‘‘ spoiling the market,” but does not threaten their lives nor their 
formal independence. As a result, the need for reforming this 
practice has lost some of its former urgency. Nevertheless, just 
as the one-price system in retail trade proved far more efficient 
and better for the trade as a whole than the older method of 
separate bargains with each customer, so some system of uni¬ 
formity will undoubtedly prove better for national markets as a 
whole, in the long run. Where the producer whose territory 
is invaded is strong enough to fight on fairly equal terms, there 
is a natural check on undue cutting in his particular market. 
He may or may not meet the cut—it is expensive to do so—but 
he can retaliate by a counter-invasion of his opponent’s home 
market. Many concerns of fair size, even when they have a 

1 This subject has been discussed at some length by J. B. Clark, The Control of 
Trusts, 1907 (revised edition, 1912, by J. B. and J. M. Clark). Also J. B. Clark, 
The Problem of Monopoly; and Stevens, Industrial Combinations and Trusts, and 
Unfair Competition. 



DISCRIMINATION IN THE MODERN MARKET 


425 


well-defined market, feel that it is good policy to maintain “ out¬ 
posts of competition” in their rival’s markets. Whatever the 
reason or justification for this, it does put them in a position for 
quick retaliation if the rival starts a poaching campaign, and this 
prospect undoubtedly acts as a deterrent to irresponsible local 
discriminations. 

Such discriminations have little value in developing new 
business. They serve chiefly to determine which competitor 
shall secure the larger share of the existing business. And the 
consumer receives a doubtful benefit, just as in international 
dumping, because he adjusts himself to a privilege which may 
vanish as easily as the wind changes, and is not likely to yield 
him long-run benefits. 

4. DIFFERENT CLASSES OF BUYERS 

The most obvious case, perhaps, is the classifying of buyers 
into wholesalers, retailers and consumers, but this is not true 
personal discrimination. These classifications correspond to 
real differences in the character of business involved. There is a 
saving in overhead in selling to retailers as compared to con¬ 
sumers; and to wholesalers as compared to retailers; and the 
regular systems of discounts have something to do with this 
saving of overhead, though the question in the manufacturer’s 
case quite as often takes the form of protecting the regular 
dealers in the margins which they need to cover their overhead 
costs. In the long run there is probably not a great deal of 
difference between these two ways of figuring, as the manu¬ 
facturer cannot do his own wholesaling nor the wholesaler his 
own retailing without largely duplicating the equipment and 
expenses of the independent dealer, but it is decidedly important 
that this question should be left open to the test of the freest 
competition, with no artificial handicaps. 

Therefore the spread between the prices at which a producer 
will sell to wholesalers and to retailers should be governed by 
the relative cost to him of the two classes of business, not the 
supposed cost to the independent wholesaler who desires protec¬ 
tion against direct buying on the part of retailers. One glaring 


426 


ECONOMICS OF OVERHEAD COSTS 


abuse of these discounts occurs when co-operative enterprises, 
which perform the functions of retailers, are classed as consumers 
and refused the regular retailers’ discount. This is a clear case of 
setting up a barrier against legitimate competition, and any such 
tactics tend to give rise to a suspicion that our mercantile 
organization is not wholly competitive and enjoys wider margins 
than would be possible under free competition of rival methods. 

The seller of a service can classify purchasers according to the 
use they make of it, for example, electricity for power and for 
light. Here there is a real difference in the cost of the service 
rendered for these two purposes, but the same device may also 
be used as a means of marking off a class of customers, merely 
because they will stand a higher toll. The Interstate Commerce 
Commission has refused to permit railroads to make discrimina¬ 
tions on this ground alone, though often the class designation of 
goods is not unmistakable, and use may enter in in determining 
it—for example: Are cowpeas peas or fertilizer? 

Discrimination between classes of buyers may also be con¬ 
cealed in charges for real or fancied differences in the quality of 
goods. A grocer takes prunes out of the same lot, divides 
them into two different lots at different prices, perhaps glazing 
one with a wash of thin syrup, and very likely sells the more 
expensive lot the faster of the two. Identical goods are sold in 
packages and in bulk at .prices which make the containers 
wonderfully expensive. The most expensive editions of a book 
are used as a method of finding those levels of demand which will 
pay a high price, and giving these taxable customers the oppor¬ 
tunity to be taxed. This is all the more effective if the more 
expensive edition comes out first, for it then extracts the high 
price from everyone who particularly wants the book while it is 
fresh, and from many who would always buy the cheaper edition 
if they had a choice. After the upper levels of demand have 
been thoroughly explored, the cheaper editions appear. Their 
cheapness is only secondarily a matter of paper and binding; 
it is primarily a case of charging what the traffic will bear. 

Another simple method of segregating classes of consumers is 
followed by department stores which instal a cheaper grade of 


DISCRIMINATION IN THE MODERN MARKET 427 

store in the basement, with less spacious accommodations, and 
a less expert selling force, where they dispose of remnants, as 
well as carry cheaper lines of goods. Here the element of classify¬ 
ing the market is no more important than the utilizing of waste 
space, putting relatively inexperienced salespersons where they 
can make large sales without getting in the way of the more 
fastidious trade, and can move the remnants and “stickers” 
without forcing the elite of the sales personnel to misspend 
their time on that secondary function. 

New and old customers, or regulars and transients, may also 
be differentiated. The low rate made by magazines to secure 
new subscribers is a well-known example, and the same thing 
is often done in selling other kinds of goods. If the old customer 
is steady and the new one is likely to be transient, this may 
furnish a ground for treating the established customers with 
special consideration: but aside from this the tactical advantage 
is all with the one new buyer whom the concern is trying to lure. 
A little thing may make all the difference between gaining his 
custom and losing it, and there is more trouble taken over him 
than over the ninety and nine who need no special inducements. 

This is one way of disregarding overhead costs to enlarge 
sales, while making them up on the established business. 
“Special offers” of all sorts come in this class, and are meant to 
catch the reluctant and wavering buyer. But there is no end 
to the devices which may be used to accomplish this purpose. 
“ Goods are put out without the usual brand, or are sold surrepti¬ 
tiously to a few favored purchasers, with stipulations against 
resale, or requirements concerning resale prices.” 1 

Another form of discrimination is the discount for cash. 
Generally a concern chooses one of two policies: to make no 
discount at all, or to make the discount in the form of a lump 
sum, a great deal larger than the interest which the customer 
ordinarily saves, and so furnish a powerful incentive to pay in 
time to get the discount. It is chiefly large concerns selling goods 
on the instalment plan which calculate discounts according to 

1 F. W. Taussig, “Is Market Price Determinate?” Quarterly Journal of Eco¬ 
nomics , XXXV (May, 1921), 410* 


428 ECONOMICS OF OVERHEAD COSTS 

the time the debt runs, and at something approaching a market 
rate of interest. 

One of the simplest forms of discrimination occurs where a 
doctor or lawyer grades his fee according to his client’s pocket- 
book. This is only partly a method of enlarging their trade for 
the sake of greater profit, since the doctor, at least, often serves 
for nothing. This kind of discrimination is a bit of social adjust¬ 
ment more than a money-making policy. It tends in the direc¬ 
tion of neutralizing the extra buying power of the rich over one 
of the most expensive and most necessary services. And the 
poorer section of a doctor’s practice obtains medical service 
which it could not pay for unless the doctor were allowed to 
collect most of his overhead from the rich. If more goods and 
services could be sold on similar principles, the rich would be 
quite as happy and the poor would have more of the necessities 
of life, without confiscating wealth or disturbing the system of 
scoring in our great competitive game wherein a man’s success is 
measured by his money income. 

Other forms of discrimination are still more personal, such 
as the free passes which used to be so common on railroads, and 
similar perquisites in other businesses in the form of discounts 
to those in the trade, and perhaps to some of their friends. 
Some forms of this will probably go the way of old-fashioned 
retail higgling, while others may make a permanent place for 
themselves. Where they cheapen the general necessaries of 
life to all the employees, they may be taken as a desirable part 
of the real wages the concern pays, and a limited approach 
toward a co-operative system. Where they concern non- 
essential goods, and are granted only to officers or those in 
commercial positions, and extended by courtesy to their friends, 
the industrial world could do quite as well without them. 

5. DISCRIMINATION BETWEEN COMMODITIES, BRANDS, 

AND GRADES 

One of the simplest and most common kinds of discrimination 
occurs through failure to discriminate: that is, charging flat 
amounts where cost and service rendered both vary. Retailers 


DISCRIMINATION IN THE MODERN MARKET 


429 


commonly charge a customary percentage above what the goods 
cost them. This discriminates in favor of goods which use 
large amounts of expensive space, goods which are turned over 
slowly, and goods which require much work to sell, either because 
they are hard to move, or simply because people buy them in 
such small lots. Where sugar is sold by the pound without 
discount for quantity, the result is to discriminate heavily 
against anyone who might wish to take 25 or 50 pounds in one 
purchase. One investigator estimated that selling, handling, 
and delivery cost about $1.90 for 100 pounds of sugar as it was 
actually handled, while if it were possible to sell a ioo-pound 
sack as a unit, the cost would be about 14 cents. As the spread 
between wholesaler and retail prices was $2.00, there was only 
10 cents left for the retailer’s overhead, and the possible gain 
from selling the same amount of sugar in fewer and larger 
packages might be quite material. 1 

The margin or spread charged by the retailer is by no means 
rigidly uniform. Sometimes it varies widely with no apparent 
correponding variation in the cost of handling the goods. A 
more systematic discrimination consists in treating certain goods 
as “leaders,” giving the customer a more than usually good 
bargain on those particular goods, and seeing to it that the fact 
is brought to his attention. One effect is to attract people into 
the store for one bargain and then sell them other things. A 
“leader” needs to be something whose quality and prevailing 
price are well known, or else it needs to be thoroughly advertised. 
A particularly grandiose stroke is to sell some universally known 
branded commodity, such as Ingersoll watches or Gillette safety 
razors, at less than the actual cost of the goods themselves. 
This, of course, goes beyond the limits of an optional distribution 
of overhead, and becomes an out-and-out gift or premium. 
It is also an injury to the maker of the goods, since it casts unjus¬ 
tified doubt upon the fairness of the standard price. In such 
cases the fixing of resale prices may prevent a genuine wrong. 

1 Based on an investigation of retail grocery stores in Portland, Oregon. 
Reported to the writer in 1923 by Miss Dorothy Poor, a graduate student at the 
University of Chicago. 


430 


ECONOMICS OF OVERHEAD COSTS 


“Stickers” have already been mentioned: the goods which 
have failed to move after a reasonable time, and are taking up 
shelf room which should be occupied by goods that will move 
faster. The goods cannot easily be made to pay the overhead 
costs chargeable against them for the past, and if they are not 
moved somehow, they will eat up a deal more overhead in the 
future. One rather short-sighted method is to give salesmen 
a premium for selling such goods, thus bribing them to divert 
their best efforts from the best goods, toward getting doubtful 
goods into the consumer’s hands—goods which will probably 
not greatly help the reputation of the concern. As already 
suggested, a markdown sale in the basement is a more appropriate 
remedy. It is usually better to accept the verdict of the public 
as to the value of the goods rather than to fight against it by 
concentrating selling effort in just those spots where it has the 
least promising materials to work with, and can do the least 
real good. 

6. DISCRIMINATION ACCORDING TO SERVICE, 
ACCOMMODATION, OR TIME 

Other types of discrimination arise in fixing prices for the 
different rooms of a hotel, the different seats in a theater, upper 
and lower berths, and other similar accommodations. The 
difference in price is not chiefly a question of cost, but of utilizing 
capacity and adapting the price to the public’s desire for the 
different parts of the service. These cases are really on the 
borderline between the general problem of utilizing a given 
capacity, and the special principle of “joint cost.” So far as the 
accommodations are essentially different, and costs cannot all 
be definitely allocated to them, there is ground for claiming that 
charging different prices is not discrimination at all. 

However, there are still the convention rates at hotels, 
“popular-priced” concerts, educational discounts to help fill up 
empty seats at improving plays which are not quite good enough 
to entice the public away from musical comedy, and the regular 
discrimination between afternoons and evenings and the different 
days of the week, or the whole field of seasonal rates. Even the 
charges and privileges at golf courses show some differentiation 


DISCRIMINATION IN THE MODERN MARKET 


431 


in recognition of unused capacity and a varying load. Into all 
these different types of practice it will be impossible to carry our 
study. They do not raise questions of serious public import, 
but they do illustrate the principle we have been discussing, and 
they show how thoroughly widespread and general the practice 
of differential price-making is. 

7. MAKEWEIGHTS IN THE BARGAIN 

Discrimination may take the form, not merely of lower prices 
but of credit, delivery, and other services, or of devoting more or 
less selling effort to the same goods without change of quality, 
service, or price. The grocery store is discriminating when it 
charges the same price with or without delivery. One of the 
subtlest forms of discrimination is that of the retailer who 
insinuates into the hands of the customer the brand of goods 
on which the manufacturer allows him the widest margin. The 
manufacturer is paying for salesmanship, or rather for the special 
favor of a salesman who is ostensibly neutral, and who needs to 
be neutral if the customer is to get reasonable access to the 
market. If the bargain were made in the open there would be 
little objection to it which would not apply to our whole selling 
system, for the producer regularly has the option whether to 
spend money on his selling force or apply the same amount 
to the reduction of prices. As it is, it warps the proper function 
of the retailer. He should either be the known agent of one 
concern or the keeper of an impartial market for the goods of 
all—preferably the latter in general retailing. 

“Service” has many aspects. The service of selling is 
branching out into demonstration, education, and even dis¬ 
interested advice. One interesting type of problem arises in 
connection with such things as automobiles or washing-machines. 
Is the producer supposed to sell a machine only or the service 
of a machine-that-goes ? If the machine does not work exactly 
right, is that because the machine was not quite as good as others 
of identical brand, or because the owner has abused it, or because 
it needs occasional adjustment in the ordinary course of opera¬ 
tion ? And in the latter case does the need of adjustment vary 


43 2 


ECONOMICS OF OVERHEAD COSTS 


with the care and skill of the operator, or with the imperceptible 
variations in the workmanchip of the machine itself? And 
should the customer be expected to make the adjustments, or 
hire them made, or will the producer be able to sell a more 
valuable service, and profit more in the end, if its own agents who, 
presumably have the proper working of the machine at heart, 
shall make all such adjustments and take the responsibility for 
keeping the machine in running order ? Truly a heavy responsi¬ 
bility, so long as mechanism is not made absolutely “fool-proof.” 
Free repairs are often guaranteed on condition that the user 
follows the printed directions accurately. This is an entering 
wedge, for there is strong pressure to give the consumer the 
benefit of the doubt and to repair damages for which his own 
clumsiness is really responsible. 

Here there is a wide margin within which it is not possible 
to say what is discrimination and what is equal price for equal 
service. The amount of free service rendered in such cases is a 
testimonial to the growth of the idea that what is sold is not a 
physical aggregation of pieces of metal, nor even an aggregation 
which will run if treated precisely right, but a service of operation, 
maintained through at least the minor vicissitudes and chances 
which occur when the ordinary inexpert human being is put in 
charge of an unfamiliar mechanical servant. 

8. CONCLUSION 

It is well-nigh impossible to summarize all the varieties of 
differential price-making which are found in business. Where 
the different bargains are so offered that the buyer has a really 
free option and therefore classifies himself, there is little chance 
for abuse and much room for general benefits. The chief 
public requisite is that there should be adequate knowledge of 
the quality of goods and services offered, so far as differences in 
quality are of serious human importance. Minor differences 
used as pretexts to extract extra dollars from those who can 
afford them may be passed over as of little public significance. 
Where the discrimination merely transfers trade from one compet¬ 
itor to another, it does little to develop greater usefulness in the 


DISCRIMINATION IN THE MODERN MARKET 


433 


industrial equipment as a whole, and has little positive value. 
Local discriminations belong for the most part in this class. 

In general, discrimination is not a sure symptom of monopoly, 
still less of extortionate prices. Nor is discrimination necessarily 
due either to monopoly or to “joint cost.” It is a natural result 
of overhead costs, and is found in practically every phase of 
business. Sometimes it is due to close figuring of costs and keen 
pursuit of profits; sometimes to ignorance of costs or failure to 
allocate them. It needs no elaborate explanation; rather, when 
it is absent, its absence needs explaining. On the whole, however, 
the more uniform prices become, the less does selling effort 
spend itself on the bargaining aspect of its work, and the more 
does it tend to focus upon real service and to make itself indis¬ 
pensable to the consumer by furnishing genuine and valuable 
guidance. Accordingly, the market will be in a better condition 
in proportion as it sloughs off all discriminations except those 
which have a clear tendency to tap strata of demand which 
would otherwise remain untapped, and to develop uses of our 
economic equipment which would otherwise remain unexploited. 


CHAPTER XXI 


CUT-THROAT COMPETITION AND THE 
PUBLIC INTEREST 

SUMMARY 

The dilemma of industry, 434—The supply of productive capacity, 437— 
The meaning of “spoiling the market,” 439—Potential competition as a limit on 
prices, 444—Is competition ruinous ? 447—The social interest in production versus 
the private interest in profits, 448—Conclusion, 450. 

I. THE DILEMMA OE INDUSTRY 

Some writer has said, speaking of railroads, that there can be 
competition somewhere, competition everywhere, or competition 
nowhere. Competition somewhere spells unfair discrimination; 
competition everywhere means cut-throat competition, and 
competition nowhere is industry’s only refuge. It is this three¬ 
horned dilemma which now invites our study. The difficulty 
has another phase, for we have seen that the public interest calls 
for production, whenever the normal capacity of industry is not 
fully used, turning out any goods which are worth the differential 
cost of making them. We have also seen that this differential 
cost is, socially speaking, next to nothing at times of general 
idleness, and therefore if industry follows this rule to the letter, 
it cannot possibly cover its overhead costs. If it can discrimi¬ 
nate it will be much better off than if it has to sell at a uniform 
price, but no system of discrimination would completely over¬ 
come the difficulty. Whenever and wherever higher prices are 
charged in the hope of covering constant costs, the result is 
bound to be some limitation of demand, and some sacrifice of 
economically desirable output. The only level of prices which 
will surely call all available productive powers into use is a 
bankruptcy level. 

Unchecked competition does actually tend in this direction; 
witness the chronic rate wars among railroad and steamboat 
lines in the early days. In theory, the same argument which is 


434 


CUT-THROAT COMPETITION 


435 


used to show how competition brings prices down to cost (so 
far as it does not rest on the intervention of new competitors) 
can be used to prove conclusively that competition tends to 
force prices down to the level of differential cost, if existing pro¬ 
ductive capacity will supply the demand at that price. And as 
industry is in a chronic state of partly idle capacity, to insist that 
producers shall compete unchecked appears to amount to inviting 
competition, and private enterprise with it, to commit suicide. 

Since unchecked competition is suicidal and cannot continue, 
can anything continue which deserves the name of competition, 
or are we living in a regime of combination and monopoly, and 
is monopoly essential to the life of private industry? This is 
a real and serious question. The answer appears to be that 
business rivalry still exists, subject to checks in the way of 
understandings and standards of fair tactics, enforced partly 
by the group ethics of the business community, partly by a 
lively sense of the need of common self-preservation, which is at 
the bottom of a deal of the group ethics, and partly by the dis¬ 
cipline exercised by the larger and stronger concerns, who can 
make it decidedly uncomfortable for smaller houses which abuse 
their privileges and overstep the limits of tolerated trading. 
Another very effective check, mentioned in an earlier chapter, 
is cost-accounting. Within what Professor Taussig has called 
the “penumbra” of supply and demand, cost-accounting can 
and does frequently govern price policy. A “standard burden 
rate,” including interest on investment, is a very powerful check 
on price-cutting. 

The chief strain, of course, is in times of business depression, 
and it is a recorded fact, so far as hours of labor performed is a 
trustworthy index, that the smaller concerns maintain produc¬ 
tion at such times with far less reduction than the larger ones, 
which bear the brunt of curtailment. The question at issue 
really involves a separate analysis of the forces governing prices 
during booms and during depressions, and the average of the 
two. We have already given some attention to the means of 
protecting the overhead costs of business in the downward swing 
of the business cycle, and the question which remains is equally 


436 


ECONOMICS OF OVERHEAD COSTS 


interesting: namely, whether prosperity makes up for depression, 
or whether there is an average resultant of net loss. 

When demand first begins to revive, the effect is not always 
an instant increase in prices. As W. C. Mitchell has shown, 
producers can for a time make increased profits out of increased 
output, without restoring prices to the level which prevailed 
before the depression set in. Costs are low, except for the fact 
that overhead costs are apportioned upon a small volume of 
output, and this can be cured by selling more goods. Further¬ 
more, the market is likely to be more actively competitive than 
usual, as the depression has broken down the agreements and 
understandings by which prices had previously been maintained . 1 
But prices do begin to rise before the plants are working at full 
capacity. At such a time competition takes the form of offering 
more for the means of production, especially raw materials. 
Such competition is just as capable of wiping out profit as the 
competition which lowers prices, and it acts in a more subtle and 
less obvious way. So long as there is unused capacity, a concern 
makes a financial gain by buying more materials and working 
them up, up to the point where the price of materials absorbs all 
the margin between the selling price of the goods and the differ¬ 
ential cost of manufacture. Thus one form of cut-throat com¬ 
petition may still exist on a rising market, so long as productive 
capacity is not fully utilized. 

While prices maintain their upward swing, this form of 
competition has little chance to act destructively. The rise 
in prices creates more profits faster than rising costs of 
materials can wipe them out. And before prices reach their 
peak, plants are working at full capacity, differential cost is 
greater than average cost, not less, and the motive to cut-throat 
competition has disappeared, provided only that the concern 
knows what is happening to its costs, which is not always the 
case . 2 The crux of the matter lies in the long-run relation of the 
supply of productive capacity to the demand. 

1 Mitchell, Business Cycles, pp. 458-59. 

3 Cf. G. E. Putnam, “Unit Costs as a Guiding Factor in Buying Operations,” 
Journal of Political Economy , XXIX (October, 1921), 663-75. 


CUT-THROAT COMPETITION 


437 


2 . THE SUPPLY OF PRODUCTIVE CAPACITY 

What governs the supply of productive capacity in an 
industry ? The usual answer is that it adjusts itself to the 
demand by the construction of additional facilities whenever 
producers see a prospect of marketing their output at a profit. 
This, it is natural to assume, will not happen until there is demand 
in sight sufficient to utilize all the existing capacity at a profitable 
price. But the thing is not quite so simple as this, and will 
repay a more detailed analysis. 

In the first place, owing to the forces already studied in con¬ 
nection with the business cycle, plant capacity is governed far 
more by the peak demand than by the minimum or the average. 
If this were not true, and if business did not build for the peak 
at the time of the up-swing, one of the chief causes of business 
cycles would disappear. This very building for the peak, timed 
as it is, tends powerfully to increase the height of the peak itself. 
True, construction does not catch up with the peak, and there are 
periods when plants cannot fill all their orders, but these shortages 
of equipment are not so large nor so prolonged as the surpluses. 
The most available figures on this point are those of shortages 
and surpluses of railroad freight cars, published by the Interstate 
Commerce Commission, but other industries show the same 
phenomenon. 

In the second place, one of the regular sources of the supply 
of productive equipment consists of individuals or groups trying 
to set themselves up in business and going through the continual 
process of weeding out the less efficient. Their primary motive 
is not to supply an existing excess of demand, but to find a place 
for themselves in the world of business; and whether this place 
is found by supplying an inevitable growth of demand, or by 
building up a new demand or by merely sharing the existing 
demand, is a secondary matter. In small-scale retailing there is 
an endless inflow of such enterprise and capital, most of which 
is soon lost. As the retailer usually rents his permanent quarters 
this does not mean an indefinite increase in the volume of fixed 
capital devoted to retailing. Nevertheless, the demand for store 


438 


ECONOMICS OF OVERHEAD COSTS 


space, and the investment of funds in it, is largely affected by 
this perpetual constituency of transients. 

In less degree the same is true of small-scale manufacturing, 
including those smaller plants which constitute a considerable 
part of the total producing capacity, even in businesses where the 
most efficient plant is a very large one, and where a few such large 
concerns hold a dominant position. The writer has been told 
of industries in which strong and canny producers, when they 
wish to expand, do not build, but prefer to let others do their 
building for them, and then buy them out after they have experi¬ 
enced sufficient discouragements to be willing to sell at a bargain. 
Such a policy tends to reduce the excess supply of productive 
equipment, but at the same time it argues strongly that an excess 
exists, sufficient to overcome the natural preference of successful 
producers for working with plants of their own designing. 

In the third place, the progress of improvements offers the 
new concern a prospect of making a place for itself, not by virtue 
of an excess of demand above the capacity of existing plants, but 
by virtue of the superior efficiency of a new plant which may be 
able to produce at a profit when older plants cannot. Where 
this fails, the new plant will still remain in the business, though 
perhaps under changed ownership; and where it succeeds, the 
old plants will usually remain, able to produce at a profit when 
prices are at their highest if not at any other time, and therefore 
worth maintaining even though there is no continuous use for 
them. The bringing into service of these semi-obsolete plants is 
one of the regularly observed features of the prosperity phase 
of the business cycle. 

In the fourth place, if regularization of industry were to be 
successfully carried out, by working to stock in dull times and 
by other measures already discussed, much of the business of the 
peak would be shifted into the hollow, and a serious question 
would arise whether the outcome would not be an oversupply 
at all times. Of course the result would soon be to check the 
building which is now carried on only for the sake of the peak, 
with the result that the first source of oversupply of plant capacity 
would be quickly cured, as the permanent growth of demand 


CUT-THROAT COMPETITION 


439 


caught up with the existing supply of plants. While the process 
was going on, there would be hard times for the capital-producing 
industries, but if regularization were brought about speedily and 
generally, this depression would not last long and would merely 
put an extra strain, for the time being, on the machinery of 
regularization. And if, as is more likely, regularization were 
accomplished slowly, the effect would be so spread out as not to 
make serious inroads on the normal rate of growth. 

Regularization would not eliminate the second and third 
causes of excess capacity, but it would tend very strongly to 
diminish one disturbing feature resulting from them: namely, 
the existence of inefficient plants which are closed a large part 
of the time and operate only at the height of prosperity. Plants 
would tend either to be operated or abandoned, and this type of 
hangers-on would tend to drop out of the business entirely. 

To sum up, it appears that there are strong forces at work 
which tend naturally to produce an oversupply of permanent 
capital, and there are decided indications that such an oversupply 
exists. 

3. THE MEANING OF “ SPOILING THE MARKET ” 

Granted a surplus of productive capacity, if a producer can 
cut prices and thereby secure a part of all his competitors’ 
business or the lion’s share of the increased business which his 
reduction of prices brings forth, he can make an immediate gain 
by cutting, regardless of whether prices cover total expenses or 
not, provided only they yield something above differential cost. 
One of the commonest ways of expressing the forces which restrain 
competitors from carrying price-cutting to the limit is to say that 
they are held back by a sentiment against “spoiling the market.” 
This phrase suggests so much that it will be well worth while to 
analyze it and see what definite things it covers. 

The first is the obvious fact that such prices will not repay 
the total sacrifices of production, even fur efficient concerns, so 
that the entire trade will go bankrupt if some limit is not set. 
This has two aspects: it may be looked at from the standpoint 
of the trade as a whole or from that of the competitor who initiates 
a cut in prices. From the standpoint of the trade as a whole 


440 


ECONOMICS OF OVERHEAD COSTS 


there is a vast difference between reducing net earnings from 
12 per cent to 8 per cent, and reducing them from 6 per cent to 
2 per cent. The total amount lost is the same, but the latter 
cut is destructive, and is resisted with far more energy and with 
a real sense of moral reprobation. 

This moral condemnation is likely to have a great deal of 
weight with the competitor who is thinking of initiating a cut 
in prices, but it may not be decisive so long as it does not prevent 
him from making a gain for himself by spreading his overhead 
costs upon a larger total output and so making his reduction of 
prices more than self-sustaining. In a typical case, trade ethics 
would deter a competitor from cutting prices if he were already 
making both ends meet, but a falling off of demand itself reduces 
his earnings, and if he is in urgent need of funds he may resort 
to measures he would ordinarily avoid. A stronger deterrent 
lies in the fact that, if his rivals are forced or provoked into follow¬ 
ing his lead, he will not hold his increased output, or only a small 
part of it, and thus his last state will be worse than his first. 
Except momentarily, the chances are all against his bettering his 
condition by cutting prices below the level which experience shows 
to be necessary to cover the overhead costs of the typical producer. 

Especially is this true if he is relatively weak and if his rivals 
are stronger, and are likely, if aroused, not to stop with merely 
meeting his move, but to set out to punish him by a war of 
retaliation. Under the present trust laws in the United States, 
it is natural for large-scale businesses to permit a fringe of com¬ 
petition to survive, some of which they have the economic power 
to extinguish. They may use this power if provoked, and the 
weaker producers know it. If the cut in prices did not carry 
them below what we may call, for lack of a better term, the long- 
run normal level, the risks would not be so great and many pro¬ 
ducers might be willing to take them, but beyond a certain point 
serious danger would begin, and there is no knowing where a 
price war will stop, once it definitely abandons the attempt to 
maintain normal prices. During the past year two rival chain- 
store systems exercised their competitive prerogatives for a short 
time by giving bread away for nothing. 


CUT-THROAT COMPETITION 


441 


In the second place, where the producer is a large one and 
his own output constitutes a substantial portion of the entire 
market, he cannot increase his business by as large a percentage, 
with as small a reduction of prices, as is tacitly presupposed in 
the theoretical economic discussions of competition. Much the 
same thing is true if he sells a differentiated product, so that in a 
limited degree the market he sells in is his own, and not a part 
of a general market shared by all his competitors. Theoretical 
competition virtually assumes that a very small cut in prices 
will secure a very large increase in business for the concern which 
makes it, so that profits are increased, so long as there are any 
profits at all. Theoretical monopoly assumes that if the concern 
cuts prices its business can increase only in the ratio of the 
increase in total demand created by the reduction of prices. 
In a typical case, a 5 per cent cut in prices might cut the “value 
added by manufacture” 10 per cent, and might increase demand 
from 2J to 7 J per cent, according to its degree of elasticity. The 
result would be a reduction of net income, such as a monopoly 
would not willingly incur. 

The type • of industry we are considering is intermediate 
between these two limiting cases, and the level to which it pays 
to. cut prices is accordingly lower than if there were a complete 
monopoly, but higher than the level set by theoretical competi¬ 
tion. This does not necessarily mean that the concern makes 
a profit at all times, or even on the average, since the theoretical 
competitive price may go down until it fails to cover all the 
operating expenses; but it means that price tends to stay well 
above the cut-throat limit represented by differential cost. 

A third way of “spoiling the market” is to increase the 
immediate sale of goods without increasing actual consumption, 
with the result that when the demand revives the goods already 
sold at low prices are there on the shelves of dealers, or stored 
up by the consumer himself, and have to be pushed out of the 
way, or used up, before new goods can get the full benefit of the 
revival. Thus it means selling goods when they are cheap 
instead of waiting and selling the same goods when they are 
dearer. In other words, regularization spoils the peak of the 


442 


ECONOMICS OF OVERHEAD COSTS 


demand. This argument has its principal force in the case of 
a large company selling in a market which is partly private. 
Otherwise the company cutting prices would get a major share 
of the total gain in the off-peak demand and lose only on its 
quota of the demand when prosperity should revive. The unab¬ 
sorbed goods they had sold during the dull period would stand 
in their competitor’s way as much as in their own. 

To call this “spoiling the market” seems to imply that unless 
regularization increases the total demand, taking the cycle as a 
whole, it is of no benefit to industry. To this there are two 
answers: regularization cannot fail to involve a material net 
increase in demand, as well as a transfer from busy to dull seasons, 
and even if it involved only a transfer it would be a benefit to 
industry in the same sense in which any improved process bene¬ 
fits it, though, like any labor-saving or capital-saving device, it 
may cause a surplus of productive power for a time, and bring 
about some financial hardships. 

A fourth form of “spoiling the market” consists in shaking 
the purchaser’s faith in the fairness or economic necessity of the 
previous level of prices. He comes to think of the lower prices 
as fair, and judges that they are made voluntarily; and therefore 
he may be resentful when they rise, and may even be provoked 
into a “buyers’ strike.” Mr. C. B. Williams cites a case in which 
the price was cut to 58 cents in order to enlarge sales in a dull 
period, though this would not cover overhead costs. When 
demand revived and the company wished to put the price up to 
65 cents, which would be a living rate, the customers objected, 
arguing that they had a right to assume that the low price would 
stand unless there were a change in the cost of manufacture, 
and that they had made their own price quotations on this 
assumption, 1 and cost of manufacture had not changed. 

This case is interesting as showing how moral considerations 
enter the market and ideas of fairness modify the more impersonal 
workings of supply and demand. The trade needs to know 
what to expect and precedents have force. However, the 
precedent of selling below total cost to stimulate a failing demand, 
See Year-book, National Association of Cost Accountants (1921), pp. 199-200. 


CUT-THROAT COMPETITION 


443 


and restoring a fair price when demand revives, is one to which 
the trade could become accustomed, especially if the producers 
who followed this policy took some pains to make clear what they 
were doing and why: in short, laid their cards on the table. 
Unwillingness to be frank in such matters, and convincingly 
frank, is undoubtedly one reason why price policies fail to have 
their intended effect. The market does not know just what to 
expect or how to interpret a given move, and therefore holds off 
when prices fall, or comes on in an uncertain and spasmodic way. 

Fifthly and lastly, “spoiling the market” may simply refer 
to this very habit the market has of responding to a drop in 
prices by waiting for a possible further drop and so decreasing 
the demand instead of increasing it. 1 As Taussig points out in 
referring to this fact, there are limits beyond which this topsy¬ 
turvy operation of supply and demand cannot go. Ultimately, 
a reduction of prices will increase demand and vice versa. But 
he also remarks that this “ultimately” frequently does nor enter 
the considerations of business men, who are always immediately 
confronted by a short-run situation. 

This form of spoiling the market is a serious imperfection in 
the functioning of our chief tool of economic guidance and regula¬ 
tion, and needs, if possible, to be brought under control. A 
moderate reduction of prices which occurs promptly and having 
once been made is not likely to be unsettled by further reductions, 
is the best instrument for reviving demand. It needs to be 
supplemented by general measures for stabilizing industry, and 
accompanied by publicity which does not stop short of making 
known the essential facts as to cost in general, overhead costs 
in particular and the reasons for the policy followed. If the 
dominant concerns lent all their force to such a policy they could 
largely control this variety of “spoiling the market,” and as a 
result, would be able to stimulate demand with a smaller reduc¬ 
tion of prices than is now required, and with less uncertainty 
and general demoralization. Under such conditions it should 
be possible to reduce prices sufficiently for all necessary purposes, 

1 This meaning is employed by Taussig, “Is Market Price Determinate?” 
Quarterly Journal of Economics , XXXV, 394-411, esp. p. 410, May, 1921. 


444 


ECONOMICS OF OVERHEAD COSTS 


without spoiling the market at all in any real sense, and such a 
situation would be infinitely healthier for business than a morbid 
fear of uncontrollable consequences which results in being 
unwilling to lower prices at all, when a reduction is the only 
effective remedy the situation permits. 

4. POTENTIAL COMPETITION AS A LIMIT ON PRICES 

Where producers have power enough to prevent cut-throat 
competition, they probably have power enough to set prices 
above a fair return on the investment, unless some force inter¬ 
venes which is more subtle and harder to bridle than the direct 
and obvious competition which they hold in check. Such forces 
exist, and may be grouped under the general term: “potential 
competition,” though this term, like “spoiling the market” 
covers a number of different potentialities which are worth 
distinguishing. 1 

Potential competition refers to the restraint exercised by the 
knowledge that an attempt to be too grasping will precipitate 
competition which is not at present active. This may mean the 
building of new plans, which sprang up in embarrassing numbers 
to plague the earlier “trusts,” before they learned the virtue of 
moderation. This is a slow and wasteful check, especially where 
the new plant has to be a large and expensive one in order to have 
a fair chance of success, but it is effective in keeping extortion 
within endurable limits. As we have seen, there is a certain 
supply of new plants to be expected in any case, but a grasping 
policy on the part of those already in the business may invite 
more of them to enter and attract men of larger caliber and 
greater resources, whose rivalry is likely to be a more serious 
matter. 

Another form of potential competition comes from plants of 
the semi-obsolete type, which will be put into operation if prices 
rise high enough to make it profitable to do so. Still another 
type comes from producers already in the field, but who are not 
at present in this particular market. They may have their 

1 For an early discussion of the force of potential competition, see J. B. Clark, 
The Control of Trusts. 



CUT-THROAT COMPETITION 


445 


markets elsewhere, but stand ready to enter this one if the 
opportunity seems favorable—perhaps they already have an 
“outpost of competition” there, which does not do a material 
amount of business, but keeps in touch with conditions, and 
stands ready at any time to serve as the nucleus of a campaign. 
Or potential competition may mean the competition of the mail¬ 
order house, the co-operative system, or the cash-and-carry store, 
which local retailers have to ward off and prevent it from becom¬ 
ing a serious actuality. Where there is a strong co-operative 
organization having its own wholesale department and to some 
extent its own factories, it exercises potential competition 
throughout the market, since it stands ready to establish branches 
wherever an opening appears promising. 

And lastly, there is the potential competition of producers 
actually in the field, which has to be reckoned with when their 
active competition is settled by agreements, understandings, or 
more informal truces. The more ambitious and grasping such 
arrangements become, the more likely some member is to break 
away from them and become an active competitor. It has 
already been suggested that this kind of potential competition 
may be a weapon for keeping prices up as well as down: that is, 
that when the sustaining of prices by large concerns gives small 
ones a chance to make easy profits by “shading” the established 
price, they may be kept from abusing their privileges by the fear 
of retaliatory warfare. 

On the whole, potential competition is a mild and tolerant 
governor of prices. It allows some profits beyond the absolute 
m inim um necessary to sustain private enterprise, but as compared 
to public regulation of prices it probably makes up for its laxness 
by the fact that it leaves industry freer from the cramping effect 
of the system of checks and balances involved in public control. 
One characteristic feature is that it tends to lose its force unless 
it now and then emerges from the background and takes the 
form of actual competition. Thus it is inherently impossible to 
have industry effectively governed by potential competition alone. 

Another unfortunate feature of this natural check on exploita¬ 
tion is that the consumer does not always get the benefit of the 


446 


ECONOMICS OF OVERHEAD COSTS 


reduction of profits. When there is a definite agreement or 
understanding as to prices and the trade is open to anyone who 
chooses to come in, the natural result is that the newcomers 
should be taken into the understanding and maintain the same 
prices, unless they are so very extortionate that it seems more 
profitable to take the chances of a price-cutting contest. This 
possibility would tend to keep the price sufficiently moderate 
so that a war would not promise large profits, and the trade 
would not be disrupted on every new arrival. Then the natural 
tendency would be for new competitors to come in, maintain 
prices, and share the existing business until ultimately profits 
came down, and prices and costs of production were brought 
together, not by bringing prices down to costs, but by bringing 
costs up to prices, by dividing the existing business up among so 
many competitors that they all had unused capacity and cor¬ 
respondingly high costs. Fortunately this process could not 
go on absolutely indefinitely, for if it resulted in very serious 
inefficiency, a new concern could cut prices, work to capacity, 
and operate at so much less expense per unit that it could make a 
profit. 

Potential competition operates under one serious disadvantage 
whenever it depends on the entry into the field of a large new 
enterprise, with heavy permanent investment. Such an enter¬ 
prise will have a very appreciable effect on the total producing 
capacity in the industry, and it may require a considerable 
reduction of prices to enable all the capacity to find a market. 
Even aside from this, the entry of a large new competitor will be 
something the producers in the field cannot let pass unnoticed. 
They will do something about it. Whatever the conditions are 
when the promoters of the new enterprise are making their 
survey of the market, one thing they can be sure of is that condi¬ 
tions will be quite different after they have started business. 
They w^ill not be let alone: going will not be so easy as the 
preliminary survey would indicate. Thus there must be a 
substantial margin of profit to cover these contingencies before 
a large amount of capital will be tied up in an investment from 
which there is no easy retreat. Hence the effect of potential 



CUT-THROAT COMPETITION 


447 


competition is quite as satisfactory where it depends on the 
relatively unobtrusive entrance of small and medium-sized 
producers, no one of whom is of sufficient importance to provoke a 
price war. 

5. IS COMPETITION RUINOUS? 

Does the competition of large business aggregates, with large 
fixed capitals, tend to force prices below a fair return on capital ? 
The test of detailed study of cases, applied to this question by 
Professor Eliot Jones, leads to the conclusion that such busi¬ 
nesses do not show the effects of ruinous competition. 1 What¬ 
ever might be the natural effects of unchecked competition, 
business has evidently developed checks sufficient to protect 
its necessary earnings, taking good and bad years together. The 
disease of chronic financial starvation is far more likely to be 
found in small-scale industries where many inexperienced man¬ 
agers are trying their hands as independent business men, com¬ 
monly with inadequate working capital and little knowledge of 
costs. 

Small-scale retailing and farming are probably the businesses 
in which investigation would reveal the nearest approach to 
cut-throat competition. The figures of farm incomes, as pub¬ 
lished by various agricultural surveys, indicate a severely pinched 
income, though there are disputed questions as to the method of 
figuring return to land, and other matters which need to be 
disposed of before these figures can be accepted as fully compar¬ 
able with similar figures for other industries. Also the farmer 
suffers little from unemployment or from the business cycle, and 
he can always eat. Despite these qualifications, however, large 
groups of farmers show convincing evidences of chronic failure 
of income to cover fair wages and fair return on investment. 2 
The industries which suffer most in times of severe depression 

1 “ Is Competition in Industry Ruinous ? ” Quarterly Journal of Economics , 
XXXIV (May, 1920), 473-519. 

2 See E. G. Nourse, Agricultural Economics , chap, xvii, C. and D. “Labor 
incomes” from nothing at all up to $400 per year appear to be typical, after deducting 
j per cent on investment. But as land values are often bid up until the annual 
rental is capitalized at only 3 per cent, 5 per cent seems too high. The difference, 
on a farm where the land was worth $20,000, would amount to $400 per year. 


448 


ECONOMICS OF OVERHEAD OOSTS 


appear to be those with a large investment in materials, on which 
they are forced to take a speculative loss. 1 Apart from these 
matters, the danger of serious financial trouble appears to be 
largely a matter of the volume of bonded indebtedness. 

6. THE SOCIAL INTEREST IN PRODUCTION VERSUS 
THE PRIVATE INTEREST IN PROFITS 

The interest of the community at large calls for the produc¬ 
tion of any goods which are worth more than the differential 
cost of producing them. The private interest of industry 
requires prices to be high enough to cover the residual or constant 
expenses of production. As a result prices are frequently high 
enough to shut off the production and sale of goods which are 
economically worth producing, for the community. And yet 
it is equally true that if the community is to be served by private 
industry, there is virtually no available way to finance the 
overhead costs except through the prices charged for goods. The 
question is, then: Can this be done without cutting off desirable 
production and bringing about economic waste of really serious 
magnitude? There is always the possibility of cutting this 
Gordian knot and establishing production on some other basis 
than that of private business enterprise: some basis which would 
permit production for human need rather than for commercial 
profit. Putting it more concretely, the worst wastes of industry 
are those of the business cycle, or are derived from it, and there 
is a very real possibility that unless private business can tran¬ 
scend its purely private character and absorb sufficient social 
accounting to keep these wastes within bounds, the result will be 
the discrediting of the system of private enterprise and a transi¬ 
tion to some other system. 

The only system which would be perfectly free to put prices 
down to differential costs would be a system of public industry 
with command of the taxing power and the courage to cover most- 

of the constant costs of production by the use of direct taxes. 

_ 

1 See Alvin H. Hansen, “Prime Costs in the Business Cycle,” Journal of 
Political Economy, XXXII, 11-13. 



CUT-THROAT COMPETITION 


449 


Indirect taxes, falling on output, would merely present the same 
difficulty in another form, and a far less healthy one for the body 
politic. And direct taxes, to the enormous amount required 
for the purpose, would be out of the question. Moreover, our 
systems of correlating taxes and expenditures do not, as yet, 
afford any check on extravagance or guaranty of apportioning 
resources according to economic needs, which is anything like 
as positive and effective as the system of prices and profits. 
With all its shortcomings, private business follows a less inade¬ 
quate system of social accounting than any which our political 
machinery has available to substitute for it. Thus we come back 
to the problem of making prices to cover constant costs, while 
minimizing the wastes of unused capacity. 1 

The chief saving fact which prevents this problem from being 
utterly hopeless has already been suggested. If everyone 
stood ready to cut prices as far as might be necessary, the worst 
of the unused capacity would disappear, and with its disappear¬ 
ance, differential costs would rise until they approximated average 
costs. Therefore, it is not necessary to cut prices to a suicidal 
point. As we have seen in connection with business cycles, the 
cutting of prices is only a part of the mechanism necessary to 
call into use a major portion of our wasted possibilities of produc¬ 
tion. Some substantial concessions are necessary, but if they 
are too great they defeat their own end by reducing the purchas¬ 
ing power of those who make them. Furthermore, when demand 
is active, it exceeds normal productive capacity, and prices can 
be put high enough to make up the necessary average return, 
without shutting off any production which the social interest 
requires. Thus the dilemma of waste due to overhead costs is 
not insuperable and cut-throat competition is not one of the 
necessary requisites of social efficiency. 

1 This dilemma is one of the central features of the economics of A. C. Pigou, 
Alfred Marshall’s brilliant successor in the Cambridge chair of economics. He 
speaks of it as the discrepancy between supply price (including overhead cost) and 
marginal supply price (differential cost), and discusses methods of making private 
net product a better measure of social net product. See his Wealth and Welfare 
(1911) and Economics of Welfare (1922). 


45° 


ECONOMICS OF OVERHEAD COSTS 


7. CONCLUSION 

The chief conclusion of this chapter may be briefly stated. 
A certain amount of informal common action is inevitable and 
necessary in modern industry, thus producing a condition which 
is neither old-fashioned competition nor complete monopoly. 
Even without definite agreements, the moral and prudential 
restraints on cut-throat competition are varied and fairly effec¬ 
tive. They are in turn limited by potential competition, which 
also takes many forms and is a loose but fairly adequate form of 
control. The result is sometimes to reduce efficiency by dividing 
up the existing business among too many producers, but this 
itself has its limits, and if the protective controls which industry 
already possesses are intelligently directed, they may accomplish 
whatever stimulation of demand is desirable in dull times without 
reducing the average yield, through the whole business cycle, to 
less than the living rate which private industry requires. Cut¬ 
throat competition is an evil, and the adaptive reactions of 
industry give rise to further evils in the way of extortion and 
bulwarked inefficiency. But these evils have natural limits 
which prevent them from growing to intolerable dimensions, 
and while no panacea can be pointed out which will eliminate 
them without substituting problems of even greater magnitude, 
much improvement can be expected from the growing intelligence 
of management and the progressive moralization of industry. 


CHAPTER XXII 

COSTS OF GOVERNMENT AS OVERHEAD OUTLAYS 

SUMMARY 

Introduction, 451—Public services and private overhead, 452—Results of this 
view of public services, 453—Services rendering special benefits, 456—Caring for 
industry’s uncompensated costs, 457—Drawbacks to partnership of government 
and industry, 457—Conclusion, 458. 

I. INTRODUCTION 

Think, for a moment, of the nation as a business house; a 
vast organization for the creation of goods and utilities. Think 
first of the goods and services which are clearly economic in 
character, but think also of all the desires, all the ambitions, and 
all the ideals which require any economic efforts for their further¬ 
ing. Forget, for the moment, that hazy dividing line which 
separates the things we are accustomed to call “economic” 
from those we are accustomed to think of under some other 
name, and think only of the needs of the mass of human beings 
and of the essential character of the functions performed in the 
satisfaction of these needs. And then think of the various 
kinds of agencies through which functions of a given kind may 
be appropriately carried on, and the ways in which the burden 
may appropriately be divided. Last of all, think of the agencies 
by which these functions are actually carried on, and the ways in 
which the burden actually is allocated, but try to think of these 
arrangements as accidents of historical development and to 
compare them with other arrangements which might be avail¬ 
able for the present or the future. Such an effort of imagination 
is enormously suggestive of experimental possibilities, even if it 
leads to no definite conclusion. 

For the present, the chief effort will be to take the principles 
which govern a business house in classifying its functions and 
expenses into direct or indirect, prime or supplementary, special 
or general, constant or variable, and apply them to all the essen- 


451 


45 2 


ECONOMICS OF OVERHEAD COSTS 


tial functions of national life, disregarding the traditional bound¬ 
aries between the private and public economies. 

2 . PUBLIC SERVICES AND PRIVATE OVERHEAD 

In a business house, certain services are directly traceable to 
certain particular products which benefit from them, and others 
are not traceable, but must be allocated on some general principle 
or other. Applying this same distinction more broadly, certain 
products go to gratify the particular wants of particular indi¬ 
viduals, who benefit from them in direct and traceable fashion, 
and others result in something of general value, enabling the life 
people lead, with the help of their concrete economic goods, to 
be a fhing of more value, but not in a definitely traceable way. 
The national welfare is a great bundle of such general services. 
More specifically, the general functions in a manufacturing plant 
enable all the special services to be carried on, though the exact 
benefit is hard to divide between particular products. 

In the same way, the general definition and maintenance of 
personal and property rights creates a system of order which 
enables the particular operations of each separate business to be 
carried on, though the benefit is hard to trace quantitatively. 
A legal case creates a precedent, under which business in general 
has to live, just as a decision made by the management of a 
business creates a precedent under which an indefinite number of 
subsequent operations are carried on. There must be a general 
system of order, co-operation and division of labor, within each 
business and in economic life as a whole, and the creation of this 
system of order is a general, not a special service. In creating 
an orderly co-operation, people have to be told both what they 
shall do and what they shall not do. Under our individualistic 
system government takes the chief responsibility for telling them 
what they shall not do, but it is not confined to this, for there are 
such things as traffic regulations, the compulsory spraying of 
orchards, and many other positive requirements. 

Moreover, in a very large section of this work of telling people 
what they shall not do, government waits for injured or threatened 
parties to take the initiative, and to prosecute a case, sue for 


COSTS OF GOVERNMENT 


453 


damages, or pray for an injunction. Part of the overhead costs 
of every industry consists of watchmen and lawyers, playing their 
part in this maintenance of order, primarily protecting the inter¬ 
ests of their own business, but secondarily contributing to the 
safeguarding and evolution of the entire system of rules and 
precedents under which business as a whole operates. 

The essential functions of government are those which could 
not be carried on at all by competing private jurisdictions, much 
as the essential functions of business management are those 
matters which could not be left to individual workmen to deter¬ 
mine each for himself, without destroying the direction, unity, 
and co-operation of the whole. But there is a vast array of 
optional functions, which might be parts of the overhead costs of 
private business or might be handled publicly. The line is an 
ever shifting one. Many things are of use to an entire business 
and to many other businesses besides. Some, like streets and 
postal service, are of use to all businesses and to all individuals 
besides. The work of the Bureau of Standards, the consular 
service and Foreign Trade Bureau, the Bureau of Mines, pure- 
food investigations, agricultural research, mothers’ bureaus, 
childrens’ bureaus, the census and the gathering of labor statistics, 
inspection and grading of goods, and various other services in 
the creation of the essential conditions of a free, intelligent, and 
fluid market in which individual demands and supplies may 
come together—all these bear a relation to industry as a whole 
or to the gratification of individuals’ needs as a whole, similar to 
the relation which the management of an industry bears to the 
direct work of turning out products. 

3. RESULTS OF THIS VIEW OF PUBLIC SERVICES 

But there is no need of multiplying instances, or of overwork¬ 
ing the obvious parallelisms which exist. What is their economic 
importance ? What effect can this view of government have on 
decisions of practical policy? On what problems can it shed 
light ? 

One effect lies in regarding government as a productive eco¬ 
nomic agency of a vital sort, a partner of industry, provider of 


454 


ECONOMICS OF OVERHEAD COSTS 


some of the most vital factors of production, and not an extra¬ 
neous burden which industry must pay for as a necessary economic 
evil but whose activities and services belong in another sphere, 
wholly separate from the economic: the political sphere, which 
at best touches the economic only to hamper business by regula¬ 
tion. Such a shift in the standpoint from which government is 
viewed cannot fail to have important effects. The modern 
enlarged activities of government need not all be classed as 
burdens; they all have a chance to show themselves economically 
worth their cost and many can even be financially self-sustaining 
in a very literal sense. Under this conception, then, govern¬ 
ment can broaden its functions without encountering the same 
sort of resistance on the part of public opinion with which a 
similar enlargement of “political” functions would be met. 
This is a very real issue, since we are witnessing a great extension 
of the work of government in the field of economic assistance, 
research, and regulation, both of particular industries and of 
industry in general. 

A more concrete issue arises from the fact that all these things 
cost money, and that the resulting need for revenues greatly 
overburdens our traditional systems of public finance. Under 
modern conditions of science and specialization, we are organizing 
and centralizing the work of guidance which each person or each 
small business used to perform individually, and are building up 
a vast intangible capital calling for a greatly increased propor¬ 
tion of our economic effort to be spent in centralized organiza¬ 
tions of one sort or another. Thus the problems of allocating 
financial burdens become increasingly pressing. 

The common way of raising public funds is on the principle of 
“ability to pay.” This is essentially the principle of “what the 
traffic will bear,” carried to the point of completely disregarding 
special benefits received or special services rendered. But 
revenue divorced from special benefit is hard to raise in such 
amounts as the enlarged tasks of modern governments require, 
without creating the sort of dissatisfaction which is fatal to any 
party at the polls. This is true even of indirect taxation, and 
still more so of direct. Fees for special services, and taxation 


COSTS OF GOVERNMENT 


455 


on the principle of benefits received are strongly indicated as 
resources for raising the revenues required by the modern enlarge¬ 
ments of the work of government. 

So far as concerns the basic services of protecting the underly¬ 
ing rights of person and property, ability to pay is one way of 
measuring benefits received, and probably the most pertinent 
way. For the government protects the property rights and 
enforces the contracts by means of which the rich acquire their 
riches, and under a different system of rights and enforcements, 
wealth would be differently distributed. Without any supreme 
central power to define and enforce these rights, there would 
be nothing like the accumulation of wealth which now exists, and 
while there would still be richer and poorer, the richer would not 
be the same persons who constitute the well-to-do class in America 
today. They would be more of the type of the late Pancho 
Villa. Thus the theory of benefits and the theory of ability to 
pay lead to the same conclusion, so far as the central system of 
maintaining order is concerned. 

But many other services cannot easily secure the funds to 
which their usefulness entitles them, unless they are recognized 
as forms of economic production, whose costs are essentially 
part of the overhead outlay incurred for the special processes 
which benefit from them. As an outstanding example of this, 
we have already touched upon the revolutionary increase in the 
volume of highway traffic and the cost of highway construction 
and maintenance, for which the automobile is responsible. This 
has revolutionized the requirements of highway financing, mak¬ 
ing it necessary to place the allocation of burdens on the same 
general economic basis as that of industrial overhead, and to 
treat a large part, at least, of the highway budget as the cost 
of a definite and self-sustaining department of economic pro¬ 
duction. 

Perhaps a still more important effect of regarding govern¬ 
ment outlays in the fight of overhead costs of industry, is the 
tendency to make specific measurement of benefits in dollars and 
cents, and to demand that total benefit shall cover total cost 
before the work can be regarded as worth doing. Especially is 


456 ECONOMICS OF OVERHEAD COSTS 

this true of those optional functions of government which are 
performed chiefly because they are more efficient if centralized, 
and the results can be made more generally useful. If govern¬ 
ment does not perform them, private industry will, if they appear 
worth its while. Hence government should not enter the field 
without a convincing showing of economic reasons why benefits 
are worth more than costs, even though they do not appear in 
that light to private industry. There is room for a very great 
extension of this sort of service, especially in the realm of indus¬ 
trial and economic knowledge. Much of it is the sort of thing 
which private industry could and should do for itself but which 
only a large concern could do effectively, on account of the heavy 
overhead costs. And the results, even if they benefit the whole 
output of a large enterprise, are less useful than if benefiting the 
entire industry, and perhaps other kindred industries as well. 

4. SERVICES RENDERING SPECIAL BENEFITS 

Thus revenues may be raised and costs paid for out of benefits 
received, with due recognition of the fact that the greater the 
benefit the greater the paying power, but also with due recogni¬ 
tion of the fact that the cost of the service is, after all, largely an 
overhead cost, and that a charge varying directly with utiliza¬ 
tion tends to prevent the community from exploiting the service 
to the full, and from obtaining some benefits which would be 
worth their cost. Thus an ideal system for financing such serv¬ 
ices would be a classified system of assessments or fees, making 
the user share with government the net profits resulting from 
use, and shrinking to zero when net profits are zero. Actual 
systems might in many cases be made to approximate roughly to 
this ideal. However, a tax on net earnings is not easy to admin¬ 
ister, and a specific tax on output, with some classification based 
on size and character of business, might be consistent with 
promoting maximum utilization, if there were a regular scheme 
of exemptions in special cases, including industrial depressions. 

One possible contrivance to the same end would be a tax based 
on previous output, averaged over a short term of years, and not 
on the output of the current year, so that an increase in business 
would never increase the tax for the same year, and would only 


COSTS OF GOVERNMENT 


457 


affect it in a retarded and diluted fashion. Thus burdens 
would be gauged by benefits received but an increase in the 
benefits would not immediately increase the burdens. 

5. CARING FOR INDUSTRY’S UNCOMPENSATED COSTS 

The case of unemployment insurance, if that were to be made 
a public function, would be an example of a class of cases calling 
for a different sort of allocation. Here the burden should be 
distributed, not according to benefits but according to respon¬ 
sibility for unemployment. This is a type of the government 
service whose function is to make good some of the costs of indus¬ 
try which would otherwise go uncompensated. Once responsi¬ 
bility for such costs is recognized, it is obviously appropriate that 
they should be levied upon industry, and should become a part 
of its overhead outlays. 

6. DRAWBACKS TO PARTNERSHIP OF GOVERNMENT 

AND INDUSTRY 

Where government performs services for the benefit of certain 
industries, thus financing what would otherwise be a part of 
industrial overhead, the resulting quasi-partnership may have 
its unfortunate side. It is not easy for government to assist 
with one hand and regulate with the other. Those engaged in 
the arm of the service which does the assisting may get the 
benefit of the suspicion due to regulation or the weariness bred 
of much investigation and a multitude of questionnaires. The 
best method which present experience suggests for mitigating 
this difficulty is to intrust aid and regulation both to a quasi- 
co-operative, quasi-public organization, in which government 
and industrial interests are both represented, after the fashion 
of the Federal Reserve System. Thus government would act 
in the guise of a partner, even in its regulative capacity, and 
should be able to avoid part, at least, of the hostility engendered 
by the regulation of wholly external, political bodies. 

In foreign trade this partnership of government and industry 
is peculiarly unfortunate, as it turns private economic rivalries 
into governmental rivalries, and is a substantial item in the long 
list of economic provocations to war. It is not so much what each 
government does that makes the trouble (though many indiscreet 


458 ECONOMICS OF OVERHEAD COSTS 

things may be done) as the vaguely magnified suspicions of what 
others are doing. Yet foreign trade requires that market infor¬ 
mation be gathered on a large scale and made available to the 
trade as a whole, and that fellow-countrymen pull together and 
fund their separate stocks of knowledge, so as to overcome the 
disadvantages under which they necessarily labor. It is probably 
healthier, if it can be brought about, to form a co-operative 
organization to gather trade information and generally care for 
the intangible overhead costs which are common to all trading in 
a foreign country. But since such an organization would 
necessarily be subject to some governmental supervision, prob¬ 
ably the most practicable course is to maintain public services of 
trade information, and make every attempt to keep them above 
the suspicion of exceeding their proper functions. 

7. CONCLUSION 

We have seen that there is a tendency for government to 
enlarge the scope of its work, rendering special sendees to industry 
or to other classes of the community, or caring for the uncom¬ 
pensated costs of industry itself. There is a growing tendency 
for these services to be looked at as things of an economic, not 
a purely “political,” character: indeed the distinction between 
the political character of government and the economic character 
of business is becoming very much blurred. Business is becoming 
distinctly political, what with employees’ representation, labor 
troubles dependent on the verdict of public opinion, and other 
similar developments. And government is becoming more and 
more economic. The political arguments and leverages and the 
sentimental oratory with which people strive to sway purely 
economic decisions of government grow more and more ana¬ 
chronistic, even at the same time that business finds more and 
more use for the arts of propaganda and the spellbinder’s gift of 
arousing emotional fervors. And we have seen that the economic 
functions of government bid fair to render inadequate the tra¬ 
ditional methods of public finance and to force a new emphasis 
on methods more like those used by large-scale business in allo¬ 
cating its overhead costs and in collecting them from the public. 


CHAPTER XXIII 


OVERHEAD COSTS AND THE LAWS .OF VALUE 

AND DISTRIBUTION 

SUMMARY 

General laws already touched upon, 459—The meaning of supply, 464—The 
equilibrium of supply and demand, 465—The worth to industry of a factor of 
production, 467—“Marginal products” in a partly idle plant, 469—Long-run 
marginal product, 470—The sum of the marginal products of the different factors } 
471—Rewards and the marginal products of the factors, 474—Fast and slow 
workers, 478—Conclusion: the economy of a dynamic organism, 478. 

I. GENERAL LAWS ALREADY TOUCHED UPON 

While this study has not been formulated in the technical 
language of economic theory, it has been constantly dealing 
with the subject-matter of economic law, from the standpoint 
of principle, rather than of bare description of fact. As a result, 
we have accumulated a considerable body of economic generali¬ 
zation, bearing on the facts of overhead costs and decidedly 
at variance with the assumptions and conclusions of that type 
of economics which searches for the conditions of a perfect 
equilibrium of supply and demand, in a perfect market. Besides 
the points which have already been brought out and definitely 
expressed, there are others of a more theoretical character, 
bearing on the fundamental nature of the thing we call “supply” 
and of the equilibrium between supply and demand, and also 
on the much disputed question of the relation between the rewards 
received by the owners of the productive factors and the contri¬ 
butions which those factors make to the joint process of producing 
goods. Before proceeding to consider these new points, let 
us review the ones already dealt with. 

1. The nature of markets .—A market is a connected system 
of purchases and sales of goods of identical kind, or so similar 
that the demand for each one is very closely dependent upon 
the prices of all the others. This system is so tied together/' 
that differentials in prices are limited but not eliminated. Prices 


459 


460 


ECONOMICS OF OVERHEAD COSTS 


may differ from place to place, subject to the costs of transporta¬ 
tion and the trouble and cost of investigating the facts and of 
making a shipment and sale. They may vary from dealer to 
dealer, subject to the customers’ inertia and “good-will.” They 
may differ from brand to brand, subject to the buyers’ willing¬ 
ness to take other brands as substitutes. All these limitations 
require time to take effect, and act progressively rather than 
instantaneously. And these differentials are not imperfections 
in the competitive market, but are essential to its “normal” 
operation, affording the producer who cuts prices his opportunity 
to profit by his move without having his gains instantly taken 
away by the action of his competitors. In a sense the typical 
large-scale manufacturer sells, not in one market but in a con¬ 
nected series of markets, so related that, given the price in 
one place, the other prices cannot be deduced from the natural 
laws of competition, though one can set down the limits 
between which such prices must lie, if competition is actively 
at work. 

2. The relation of prices to human values. —As between present 
and future, high prices may or may not measure high values 
in terms of human need. Whether they do or not depends 
entirely upon whether the high price represents general scarcity 
or general prosperity. In the case of the business cycle—the 

/ most typical cause of large swings of prices—high prices measure 
prosperity and therefore do not measure high values in terms 
of human need. Therefore the regulating effect of prices, in 
putting goods where they will do the most good, is to that 
extent reversed. 

3. The variable supply of productive effort. —It is customary 
to assume that a community possesses a given supply of labor 
and capital, and that under any conditions this supply will 
be so utilized that more production of one thing means less 
production of something else. This conception has done duty as 
an argument against various social get-rich-quick nostrums, and 
especially against the protectionist fallacy which assumes that 
if protection results in building up an industry it has created 
all the wealth the industry produces. The opposite view, that 



LAWS OF VALUE AND DISTRIBUTION 


461 


it has merely directed the country’s resources and energies into 
one channel rather than another, rests on the assumption that 
the sum of resources and energies is constant. For the purpose 
in hand, this is nearer the truth than the protectionist position, 
though it needs some qualification. But when we come to the 
characteristic problems of overhead costs, we find that they 
center in the fact that the community is not able to make avail¬ 
able the utmost powers it possesses, and that the amount which 
it does manage to call forth and utilize is continually fluctu¬ 
ating, so that if by any device more of our existing energy can 
be called forth, there is a clear increase in wealth, which may 
take the form of capital or consumers’ goods, or both. Making 
more of one thing without, therefore, making less of anything 
else is a typical occurrence where overhead costs are concerned. 
Though it always takes place between limits, the limits are 
sometimes quite wide. 

4. The nature of competition .—Competition is necessarily 
a thing of self-imposed restraints, governed by the folkways 
of the business community even more actively and consciously 
than by the underlying restraints imposed by government. 
These latter consist, primarily, of the protection of personal 
and property rights, most of which are taken for granted and do 
not require much expenditure of thought except on the doubtful 
fringes of legality. Agreements, understandings, and the senti¬ 
ment against “ spoiling the market” all play a part in restraining 
competition, and are limited in their turn by some of the various 
forms of potential competition. Some of the forces of potential 
competition do not begin to act until the earnings of the capital 
engaged in the business are materially above the minimum rate 
necessary to attract free capital; while some of the forces of 
active competition continue to act even after prices are below 
the level necessary to cover operating expenses. Thus competi¬ 
tion is a varied and elastic thing. 

5. Competition acts either to lower prices or to raise the amounts 
offered for the factors of production , or both .—When demand 
is strong, competition may actually force producers to raise the 
price of finished products, when otherwise they would refrain. 


I 

r 



462 


ECONOMICS OF OVERHEAD COSTS 


For it urges them to bid up the prices of materials and so increase 
the costs of production. This bidding up of the prices of mate¬ 
rials may go to the length of cut-throat competition, but is not 
likely to do so, since the expansion of demand keeps ahead 
of it up to the point where there is no more idle capacity. 

6 . The market regularly transforms constant costs into variable .— 
The passing on of products and services to serve as means of 
further production results in converting the overhead costs of 
making these intermediate goods into direct or variable expenses 
to the industry which uses them, thus falsifying the picture 
the cost accounts give of the relative amounts of constant and 
variable costs. Hence financial accounting and cost-accounting 
on business principles do not fairly represent the actual behavior 
of the ultimate costs of industry, most of which are constant 
with reference to the ups and downs of the business cycle, 
and variable only where the alternative to production is not 
idleness, but some other productive activity. The two may, 
nevertheless, be brought a great deal closer together. This 
can be done in part by developing new forms of contracts, for 
the proportion of constant to variable costs in a given industry 
depends upon the forms of contracts under which they secure 
the use of labor and capital. In part, also, the change may be 
made simply by a broadened recognition on the part of industrial 
managers of the true social accounting in the case. The scope 
of the business man’s notion of costs is being much enlarged, 
and is capable of being well-nigh revolutionized. 

7. The human costs of labor have a two-sided aspect .—One 
phase depends upon the fact that the laborer is a conscious 
being, and from this angle the measure of cost consists of the 
incentives necessary to overcome his reluctance to work. This 
is based partly on fatigue as the worker feels it: namely, in its 
aspect as an unpleasant physical sensation, partly on a number 
of other qualitative features of the work and working conditions 
and partly on the enticements of leisure. The second phase of 
the cost of labor views man as a physiological mechanism, 
taking for granted that maintaining the mechanism in good 
condition is of paramount value to its human tenant, whether 


LAWS OF VALUE AND DISTRIBUTION 463 

he thinks so or not, and whether he knows enough to care for 
his maintenance intelligently or not. 

In general, it appears that the differential sacrifice of 
additional labor, within the limits of a physiologically normal 
working-day, is negligible from the physiological point of view, 
and even from the point of view of the worker’s reluctance to 
work, its money equivalent is far less than its pro rata share of 
the necessary cost of maintaining the laborer. A large part 
of this cost, then, becomes a “constant cost” when labor is 
working at less than desirable capacity, whether from the point 
of view of physiological upkeep or from the point of view of 
reluctance to work and the need of stimulus. The ultimate 
cost of labor is not a variable cost in the sense commonly assumed, 
but is predominantly a cost which does not vary with output, 
within the limits set by some of the more pressing and practical 
problems of increasing utilization. 

8 . Social overhead costs. —Finally, we have seen that govern¬ 
ment bears expenses which are essentially parts of the overhead 
costs of industry. It may render services, chiefly by way of 
research and information (which are overhead costs when the 
industry takes care of them itself), or it may simply regulate 
(as the management of a business regulates the doings of the 
individual workers), or it may care for damages and costs which 
the industry in question has, for some reason, not compensated. 
All these are forms of social overhead, and it is in the nature of 
things that they should be so treated. Government furnishes 
some vital, if intangible, factors of production; and produces 
far more than it costs. In one sense its claims are deductions 
from the general product of industry, but in another sense they 
are only a part of what government itself produces. We shall 
return to this question shortly. 

These are not all of the general laws and assumptions touched 
upon in the preceding pages, but they are enough to indicate 
a very significant revision of the simpler laws of the equilibrium 
of supply and demand, as well as of the conception of economic 
efficiency in the large under which the “law of supply and 
demand” seems to stand for some valid economic good, fit to 


464 


ECONOMICS OF OVERHEAD COSTS 


command the allegiance of men, or at least their satisfied acquies¬ 
cence. It remains to look more particularly at some matters 
which are implied in the foregoing discussion, but which have 
not been formulated. 

2 . THE MEANING OF SUPPLY 

The “law of supply and demand” implies that there is a 
force, acting from the side of supply, which exerts some controlling 
influence on prices, and this is commonly thought of as resting 
at bottom on the physical stock of goods, when it is a case of 
a short-run situation, and on the physical rate of output when 
it is a question of long-run equilibrium. The physical stock 
of goods, of course, is important chiefly from the standpoint 
of the rate at which it will have to be assimilated in order to 
prevent an undue accumulation. Thus the question of the 
present physical stock merges in an estimate of the future rate 
of replacements, except where goods are perishable (which 
includes such things as going out of style, becoming shopworn, 
or losing the value which comes from being the ‘‘latest thing”). 

In the long run, rate of depletion and rate of replacement 
must be in equilibrium, and this is the most important sense 
in which supply and demand tend to be equal. But the rate 
of replacement is not an independent physical fact; it depends 
upon the relation between prices and costs of production, includ¬ 
ing the elastic behavior of costs wdth more or less complete 
utilization of productive capacity. Thus the underlying physical 
■'""Tact is not supply of goods but supply of capacity to produce 
them. It is this which determines, over moderately long periods, 
how large an output a given price will call forth. 

This fact is forcibly exemplified in every case where the thing 
produced is a service, especially such things as railroad haulage 
and electrical current, and in every case where goods are made 
to order. For here there is no supply apart from demand; 
current is not supplied except as some customer turns on the 
switch and lights his light. Supply and demand are not only 
equal, but identical, unless the power fails or the supply of 
freight cars runs short. The only supply which has any existence 


LAWS OF VALUE AND DISTRIBUTION 465 

separate from demand is the supply of productive capacity, 
and the question whether supply and demand are equal, or 
what is ti e effect of supply on price, can have no meaning 
except as “supply” refers to supply of the means of production 
or “readiness to serve.” 

3. THE EQUILIBRIUM OF SUPPLY AND DEMAND 

Viewing supply in this aspect the obvious and outstanding 
fact is that it does not equal demand, nor tend to equal it exactly, 
not even on the average of its fluctuations. In a perfect static 
state where there were no business cycles nor other unpredictable 
irregularities, supply would come much nearer to equality with 
demand, but there would still be the daily, weekly, and seasonal 
irregularities which will last as long as people take vacations 
at the same time of year, and pay other people to feed, transport, 
and amuse them. And every irregularity results in a definite 
tendency for the supply of productive capacity to exceed the 
average demand, being governed largely by the peak. 

Idle labor looking for jobs is an unmistakeable example of sup¬ 
ply in excess of demand, and no theory of wages can be realistic 
which ignores this patent fact and its powerful effect on the 
entire labor situation. Idle capital is only less obvious because 
it stays in its usual working-place, supported and cared for by 
its usual guardians, and does not wander about the streets asking 
for work. In times of depression, prices of goods and rates of 
wages do not come down to the point where demand for the 
ultimate factors of production would be equal to supply. They 
are pegged at higher levels which hark back to the more active 
times which trade has enjoyed, and hopes to enjoy again. There 
is a sag, but it is like the sag of a rope stretched across a chasm, 
and does not reach bottom. These sustaining forces take 
varied forms, which have already been discussed, especially 
in connection with the ultimate costs of labor, and cut-throat 
competition. 

What is the supply of labor ? The amount actually employed 
at any time measures demand rather than supply, and the poten¬ 
tial amount which can be employed is an indefinitely elastic 


466 


ECONOMICS OF OVERHEAD COSTS 


thing whose limits we must pray never to know, for such knowl¬ 
edge could only come from some appalling catastrophe. For 
ordinary purposes the maximum volume of labor powe* employed 
during a typical business cycle, plus the minimum amount of 
involuntary unemployment, is probably the most available 
index of the normal supply of labor power which the population 
/embodies. And it is always in excess of the effective demand. 

Another very noteworthy fact which has confronted us in 
the study of business cycles is that the reduction of demand, 
.which occasions unemployment of labor and capital, constitutes 
so serious and definite an injury that there is coming to be a sense 
of obligation for the maintenance of steady demand and of 
responsibility for the results of failing to maintain it. Producers 
come to have almost a rudimentary sort of right in the mainte¬ 
nance of demand for their products. They have responded to 
previous demands by investing their working lives and their 
capital to supply them, and have by that very fact made them¬ 
selves to some extent dependent on the continuance of the 
demand for that general class of services and facilities. Their 
claim to continuance of demand may be called a natural right, 
in the rather elastic sense that too great disregard of it brings 
a natural punishment in the form of a general convulsion of 
the whole economic system. 

/ The idea that anyone has an obligation to furnish demand, 
or rather, having once furnished it, to see that it does not collapse 
—this is a strange conception to find its way into an economics 
which is accustomed to taking demand as the ultimate starting- 
point of economic study, and the seat of economic sovereignty, 
responsible to no one. Producers, in this scheme of thinking, 
had the privilege of doing their best to anticipate the whims of 
demand, but there were no obligations on either side, either of 
continued service or continued patronage. Such obligations, 
of course, are bound to be defined in the light of reason and 
common sense, or they will never be made effective at all. 
People must be able to buy things without being obliged to keep 
on buying the same things forever, but they may incur some 
obligation to arrange their buyings with reasonable care so as 


LAWS OF VALUE AND DISTRIBUTION 


467 


not to create wanton irregularities, and to finance the general 
burden of industrial irregularity, in proportion to their share in 
causing it, and in profiting by irregular use of industrial facilities. 

Another vital fact is that demand and supply are so related 
that the way to maintain demand is to maintain supply, by 
keeping industry in motion. It is a commonplace that, no 
matter how much people may want goods and no matter how 
vital their need, their wants count for nothing as demands 
unless they have money to spend, which in most cases means a 
share in the product of some going industry. This amounts, 
then, to the financial way of saying that unless people have 
something to give they can get nothing, and there is no economic 
gain in satisfying their wants. Idle labor is performing an' 
industrial function of the “ readiness-to-serve” variety, but it 
is not one which commands financial recognition under customary 
forms of contract. If idle time were paid for at the same rate 
as busy time, the problem of maintaining demand would settle 
itself, and this would react in the direction of maintaining produc¬ 
tion in general, though with no guaranty that every particular 
gap would be filled. But it would not be practicable, nor 
necessary, to pay the same wage for idleness as for work. 
moderate compensation for idle time, falling upon industry as 
a cost of idleness, would furnish an incentive capable of working 
wonders in the way of regularizing employment. The market 
would gain some support from the spending of the unemployment' 
pay, but more from the greater number of laborers with wages 
in their pockets for work actually done. 

Hitherto only the more abstract and impractical breed of 
economists have interested themselves in the proposition that 
demand and supply are not separate things at all, but two sides 
of the same thing. Today, from the standpoint of curing the 
business cycle, this is one of the most practical and obstinate 
of realities: it confronts us as “a condition and not a theory.” 

4. THE WORTH TO INDUSTRY OF A FACTOR OF PRODUCTION 

Industry' is accustomed to the general idea that its payments 
for the factors of production are governed by what those factors 


468 


ECONOMICS OF OVERHEAD COSTS 


are worth to the industry. But if the question were raised how 
the worth of a barrel of flour is divided up among materials, 
land, buildings, machinery, direct labor, indirect labor, manage¬ 
ment, and possible patented processes (not to mention govern¬ 
ment), the answer of the typical business manager would not 
be satisfying. When wages rise, people will testify on almost 
any street comer that the new rate is more than labor is “worth,” 
but this generally means only that labor is now worth more than 
it used to be. Or it may mean that if the claims of all the other 
factors remain as they are, the whole product of industry will 
not suffice to pay the new rate of wages and still support the 
other factors in the style to which they are accustomed. In 
either case the meaning harks back to the customary rate, either 
for labor or for the other factors, and has nothing more absolute 
to stand on. 

One school of economists has attempted to give the notion 
of the worth of the productive factors greater precision, claiming 
that their worth consists of their “marginal contribution to 
the product.” This means the difference in the product caused 
by allowing industry one unit more (or one unit less) of a given 
factor of production, to work with. About this conception 
volumes of acute and subtle controversy have been written, 
and it is no part of the task of this book to review this entire 
literature or settle all the issues raised. The present undertaking 
will be limited to indicating what marginal product means, 
in the simplest possible case, what are the essential conditions 
of its serving as a guide to the distribution of the whole product 
of industry, and what effect the facts of overhead costs have 
upon these conditions. We shall find that the outstanding 
features of our answer are implied in things which have already 
been said, and that it only remains to translate them into a new 
terminology and to show their implications. As we should 
jjxpect, where overhead costs are a substantial item, the perfect 
theoretical equilibrium is not found. And as it is easier to see 
these tangible discrepancies than to visualize the conditions 
of the ideal equilibrium, we can do better if we look at the excep¬ 
tion first and the rule afterward. 


LAWS OF VALUE AND DISTRIBUTION 


469 


5. “marginal products” in a partly idle plant 

When a plant is partly idle, a 5 per cent increase in the direct 
labor and perhaps a 2\ per cent increase in indirect labor will 
increase the output approximately 5 per cent. This 5 per cent" 
increase in output is what economists would call the “marginal 
product” of this addition to the labor force: it represents their 
immediate productive worth under the existing conditions.' 
Now if these laborers were paid what their marginal product 
is worth, and other laborers of the same grade were paid the 
same rates, the whole value of the product would be absorbed 
before all the operating expenses were covered, leaving nothing^* 
for the owners but a deficit. One thing might prevent, namely, 
if the last 5 per cent of output sold for a lower price than the 
rest. Then labor might get its “marginal product” without 
ruining the concern. 

This is merely an unfamiliar way of stating a familiar fact: 
that with some capacity unused the differential cost of producing 
more goods is low, and it pays to sell them for anything above 
differential cost, but if all goods are sold as cheap as this, the 
concern will not even cover all its operating expenses. Hence 
it must either discriminate, cutting prices to market additional 
goods while keeping prices up on its existing output, or it must 
decline chances to make and sell goods which would more than 
cover their differential cost (and would employ labor whose 
differential or marginal product would be more than its wages^ 1 
This means that when a concern protects its overhead and 
refuses to engage in “cut-throat competition,” it is paying labor 
less than its immediate marginal product. Fixed capital, being 
in excess, has for the time being no marginal product worth 
attempting to figure, and if it receives any earnings, they are 
a deduction from the marginal product of labor. 

In the long run and on the average of ups and downs, fixed 
capital does have a differential productive worth, and the differ¬ 
ential product of labor does not absorb the whole income of the ^ 
concern, in the long run. 1 We shall look into this long-run 

1 The terms “differential” and “marginal” are here used interchangeably. 

“ Differential ” is a more appropriate term for quantities which are not infinitesimal 
units of an absolute homogeneous whole, but have some size and some individuality. 


470 


ECONOMICS OF OVERHEAD COSTS 


equilibrium in a moment. Yet nearly every market situation 
js a short-run situation. Long-run considerations govern the 
man who is thinking of erecting a plant, but after he has built 
it, short-run considerations are very urgent upon him and every¬ 
one else. This is another aspect of the fundamental dilemma 
of overhead costs. It means that industry cannot afford at all 
times to pay labor its full short-run marginal product, because 
this would leave nothing to cover the long-run marginal product 
of capital; the two between them absorbing more than the whole 
product of industry. 

This is not a peculiar or exceptional condition, but is a special 
case of a more general law, which cannot be elaborated here, 
but which can be briefly indicated. Those factors of production 
which are responsible for the variable expenses behave in such 
a way that, in general, the sum of their marginal contributions 
tends to absorb the whole product of the industry, and other 
factors can get their rewards only as a deduction from the 
marginal products of the variable factors. 1 Capital is a variable 
cost in the long run, as we have seen. That is, output cannot 
be indefinitely increased without more capital, or some other 
adjustment which would recognize in another way the fact that 
output is partly governed by the supply of capital. There¬ 
fore, capital has marginal productive importance, because there 
may be more or less of it, and less capital means less product, 
while more capital means more product. But if there are any 
forms of capital of which this is not true, whether privately or 
publicly owned and administered, then they have no “marginal 
product” and any income they receive is a deduction from the 
marginal products of the rest. 

6 . LONG-RUN MARGINAL PRODUCT 

What is this long-run marginal worth of capital? How 
does it arise, what does it look like, and who measures it? It 
arises (to take a simple instance) when a plant needs enlargement 

1 “Variable expenses” here means expenses which vary in proportion to out¬ 
put. This statement, then, is only true so far as there are expenses which behave 
at least approximately in this way. It is also true for the “ total differential costs” 
(total costs less residual costs), but to formulate it in these terms would be a clumsy 
task. 


LAWS OF VALUE AND DISTRIBUTION ' 471 

to save it from the prohibitive costs of pushing the existing 
equipment beyond its capacity, and working night shifts or 

1 

employing an undue amount of overtime. It enables, let us 
say, 50 per cent more labor to be employed by a given enterprise 
and employed to as good advantage as those already there, 
rather than being so handicapped that their effectiveness would 
be seriously reduced. This is what would happen if increased 
capital did not at least keep pace with increased labor. Since 
it actually does more than keep pace, the excess has to find some 
uses less productive than this very obvious and very vital one. 
As we have seen, the excess may go to build more plant capacity 
of the old sort, which will be useful only at the peak of prosperity, 
and of doubtful long-run use even then. Or it may go into 
improving existing plants in a way which does not call for addi¬ 
tional labor but gives existing labor better machinery to work 
with, and results in a moderate increase in the average product 
per laborer so long as the plant operates. This moderate increase 
is the long-run marginal product of capital. 

Where does it exist and who measures it? It can only be 
measured where capital has been put into some new form and it 
can only exist where capital is free to be put into new forms. 
The best place to measure it is in the calculations of an engineer, 
estimating whether it will be cheaper to do a given piece of work 
by hand or with automatic machinery. It is decisions of this 
sort which determine the disposal and usefulness of the com¬ 
munity’s marginal supply of capital. If automatic machinery, 
with the same amount of labor as before, will turn out more 
goods, that increase is its marginal product; or if it will turn out 
the same amount of goods with less labor, then the saving of 
the labor is its marginal product, and is worth whatever the 
labor is worth. And this means whatever that much labor can 
add to the product of industry somewhere else. 

7. THE SUM OF THE MARGINAL PRODUCTS OF THE 

DIFFERENT FACTORS 

If all costs were variable, then the propositions laid down in 
section 5, above, would mean that the sum of the marginal 


472 


ECONOMICS OF OVERHEAD COSTS 


( s 

products of the different factors in any enterprise (each multiplied 
by the amount of the factor) would always equal the whole 
product. This is also what is required if price is to cover all 
the economic sacrifices of production and no more. Is this a 
law, a coincidence, or an impossibility? A little analysis will 
show that it is a law, not a coincidence, though like most economic 
laws it does not work with absolute accuracy, and it does not 
apply at all to any factors representing constant costs of pro¬ 
duction. 

Let us start with an illustration of the simplest kind, and the 
kind which is customarily made in working out this law. Suppose 
ioo acres of land, cultivated with 1,000 days' labor per year, 
and raising 20 bushels of wheat to the acre. Suppose culti¬ 
vation has reached the normal stage of diminishing return tor * 
further application of labor to the land, and that accordingly 
1,050 days’ labor per year on the same 100 acres would yield 
2,060 bushels. This means that the marginal product of labor 
is 60 bushels for 50 days or i| bushels per day, for the twenty- 
first “dose” of fifty days’ labor. 

But this also means something more. Suppose we have 
1,050 days’ labor to spend on 100 acres, and are offered 5 extra 
acres of land. This would restore the original “proportion of 
factors,” and the crop would then be 20 bushels per acre again, 
or 2,100 bushels in all. This involves no new assumption except 
that the product per acre is the same whenever the amount of 
labor per acre is the same—a premise we shall examine in a 
moment. Granting it for the time being, 5 additional acres 
of land have added 40 bushels to the product, and the marginal 
product of land is 8 bushels to the acre, when land and labor 
are in this proportion. Evidently land also is subject to dimin¬ 
ishing return, as it must always be when labor is in that stage 
and the law of proportion of factors is working undisturbed. 

Eight bushels per acre multiplied by 105 acres gives 840 
bushels, iy bushels per day’s labor multiplied by 1,050 days gives 
1,260 bushels. This added to 840 bushels gives 2,100 bushels, or 
precisely the total product. That this is a law and not a coinci¬ 
dence the reader may test for himself, using any figures he likes 



473 


') 

LAWS OF VALUE AND DISTRIBUTION,/ 

/ 

so long as they abide by the crucial assumption^ of this problem. 
The truth is that the marginal products of land and labor are not 
separate facts, they are merely two sides of the same fact, and 
they are so related that the sum of the marginal products must 
equal the whole. This same thing holds true for any number 
of factors and has been demonstrated algebraically, always 
granting the fundamental premise that the product per unit 
of any one factor is always the same when the proportion of 
factors is the same. 1 This virtually means that all expenses 
vary exactly in proportion to output. It would be roughly 
true, in the long run, of concerns which have reached standard 
size, so that further growth yields neither increasing nor decreasing 
cost but requires a harmonious proportionate expansion of all 
the factors >of production. In other words, it is a case in which 
there are no constant costs, and all costs vary exactly in propor¬ 
tion to output. 2 

But if there are constant costs ? They stand for factors of' 
production which have unused capacity. What is their marginal 
product ? An addition to the supply of such factors, might add 
nothing at all to the product, while to take away part of an 

1 See Wicksteed’s pamphlet: “An Essay on the Coordination of the Laws of 
Distribution/’ London, 1894, and review by A. W. Flux, Economic Journal , IV, 
308-13. Flux reduces the demonstration to a mere showing that this is a case 
under Euler’s theorem of a homogeneous function of any number of variables. 
The product of industry is a “homogeneous function” of the factors of production 
if, so long as the proportion of factors remains constant, product varies exactly in 
proportion to the amount of the productive factors at work. The same demon¬ 
stration has been independently made by Professor C. W. Cobb, of the department 
of mathematics at Amherst College. Edgeworth has also commented upon this 
theorem, considering the assumption of a homogeneous function too unreal. It 
certainly does not fit the facts of overhead costs, as the accompanying discussion 
shows. 

2 One further corollary of this proposition is worth noting, though not germane 
to the question of overhead costs. It is the fact that land has a “marginal prod¬ 
uct” in exactly the same sense as labor. Economists have commonly said that 
the reward of land differed from that of the other factors, because labor, for 
instance, received its marginal product, while land rent was a surplus above the 
marginal product of the labor which worked on it. True, but this surplus is the 
marginal product of the. land, and the reward of labor could be equally well figured as 
a surplus. Both methods of figuring apply to both factors. See Flux’ review of 
Wicksteed, cited above, p. 312. 


( 


474 • ECONOMICS OF OVERHEAD COSTS 

organic, specialised plant might destroy its entire productive 
power. Thus the marginal product might be everything or 
nothing. In the long run most of these factors reach the limits 
‘ of their capacity and have to be enlarged and the economies 
of enlargement somewhere come to an end. But in the meantime 
much may happen. 

8 . REWARDS AND THE MARGINAL PRODUCTS OF 

THE FACTORS 

If a concern striving to enlarge its output bids for the variable 
factors of production up to their full immediate marginal worth, 
it will end by paying them all its gross income, and having 
nothing left to pay for its constant factors. This is precisely 
what cut-throat competition means, though it generally takes 
the form of cutting the price of the product until it will no longer 
cover the overhead costs. 

Under these conditions the actual rewards of the productive 
factors depend chiefly, not on their marginal worth in time of 
depression, but on their worth during those “normal” times 
(considerably better than the average) when the capacities of 
the fixed equipment are fully utilized, when there are no econo¬ 
mies of increased output, and the sum of the marginal products 
of the factors equals the whole income of the business. Wages 
and interest are governed by this as a limit, but wages, at least, 
seldom or never reach it. They remain somewhat below it in 
busy times, leaving the concern a surplus for profits, and they 
are still lower in dull times, when the concern pays its bond 
interest out of the marginal products of its variable factors of 
production. 

This is on the assumption that the marginal product of labor 
means the worth of the marginal man actually employed in a 
given industry. Using the term in this sense, wages must 
nearly always be less than marginal product so long as business 
is run on old-fashioned business principles. And if the marginal 
product of labor means what the last man would add if all the 
unemployed were set to work, then no one knows what it is, 
partly because no one knows just how full the factories would 


LAWS OF VALUE AND DISTRIBUTION 


475 


be if all the unemployed were working, and partly because no 
one knows what would happen to the values of different com¬ 
modities and to the scheme of values as a whole. 

The natural view is that values would collapse through 
overproduction, and that, therefore, wages would have to be 
far lower than they are even at the bottom of a depression, 
in order to make it commercially possible to hire all the unem¬ 
ployed. According to this view, if the marginal product of 
labor meant the worth of the last employed laborer, it might 
be next to nothing. 

There is reason to doubt this view, and one can only hope 
with the utmost earnestness that measures for reducing 
unemployment may go far enough to furnish some approximation 
to a test, because the test would be virtually certain to disprove 
the theory. It would require nothing short of a miracle to 
eliminate all unemployment, as we have already seen in an 
introductory discussion (chap, ii, sec. n). Everyone concerned 
would have to stand ready to cut his demands without regard 
to his long-run necessities, including capital, dealers who have 
bought a stock of goods at former higher prices, and laborers 
who are least able of all to make the cut. But if this miracle 
were to happen, another miracle would follow, for each industry 
would protect the demand for everyone else’s product by keeping 
its own employees working and buying goods. Thus no one 
would have to cut very far; the readiness to do so would be the 
chief thing needed to save the situation. 

To be sure, if we end the waste of unemployment, our national 
dividend will increase so greatly that we shall have to devise 
some new forms in which to put our increased consuming power. 
However, there is little danger of our solving the problem sud¬ 
denly enough to create real difficulty on that score. A io per 
cent increase in effective use of labor, distributed over twenty 
years, will hardly be felt, especially as some of the increased earn¬ 
ing power may be taken in increased leisure (it is the form and di¬ 
stribution of unemployment, rather than the fact of not working, 
which makes the real trouble) while some of it will go into public 
works of various sorts. And if there is still some difficulty 


476 


ECONOMICS OF OVERHEAD COSTS 


remaining, the task of solving it will furnish all the more 
employment to the country’s brain-workers. 

In view of all these compensating forces, there can be little 
doubt that the marginal product of labor, if the vicious circle 
of unemployment could be broken, would be higher, and not 
lower, than wage rates are today during a depression, in terms 
of what money will buy. However, that is not capable of proof. 

But we have not done justice to the factors of production, 
which are “constant” even in the long run and which have no 
distinguishable marginal product. What are these factors ? 
They include, broadly, all kinds of industrial and commercial 
knowledge, and all those still more intangible assets which are 
not so much knowledge as habits of action: valuable lines of 
least resistance. In short, it includes the entire intellectual 
and imponderable overhead, whether it is handled by government 
or traders, whether it is held as public wealth, private property, 
or “free goods.” This includes those services of government 
without which industry could not go on, and which are in 
the large sense factors of production of a very vital sort. It 
also includes, with a qualification, such things as patented 
processes. 

In terms of the productivity theory these factors are in an 
anomalous position. They make a valuable contribution— 
often an indispensable one. Yet to exact as their share even a 
part of what they have contributed, they must take it as a 
deduction from the marginal products of the variable factors, 
because there is no other possible source; the products of the 
variable factors between them absorb the whole dividend. The 
sum of the assignable parts is unfortunately greater than the 
whole, on account of the constant elements which cannot be 
valued marginally. 

This proposition takes an interesting form in the case of a 
patented invention. Royalties, of course, cannot be more than 
the difference between the product created with the help of the 
invention and the product which would be secured by the best 
available unpatented methods. Therefore, they are limited to 
what may be called in one sense the differential product of the 


LAWS OF VALUE AND DISTRIBUTION 


477 


patented process itself. Nevertheless, it remains a deduction 
from the present product of the other factors, and if patents were 
perpetual, the sum of these deductions would come to constitute 
an intolerable burden on industry, loading it with taxes corre¬ 
sponding to no present sacrifices of production on anyone’s part, 
and largely crippling the usefulness of the world’s stock of indus¬ 
trial knowledge. 

It is only by making such things free as fast as possible that 
industry can be enabled to pay the variable factors of production 
even approximately the worth of their marginal product, and 
to bring into existence even approximately all the goods which 
it is humanly worth while to produce. Industry must stand 
on the shoulders of previous generations. It cannot get on 
without the free use of knowledge, and some other things, which 
have cost their original creators much sacrifice. So far as it is 
impracticable to turn these things immediately into free goods, 
they must be paid for, and to pay for them the variable factors 
must accept some deduction from their marginal products. But 
every such deduction is to some extent a drag on the full utiliza¬ 
tion of the world’s productive powers, and one requisite of 
efficient social organization is to keep these deductions down 
to the lowest amount reasonable and practicable. 

It does not require perpetual patents to lay an unduly heavy 
burden on industry. The mere fact of business secrecy and 
privacy constitutes an enormous waste, each industry treasuring 
its own poor secrets in order to be able to take a profit out of 
the increased effectiveness they give to the factors of production, 
and lacking the imagination to guess that other producers have 
secrets quite as valuable and that they would gain vastly more 
than they would lose by exchange. One great service performed 
by the report of the “ Hoover Committee” on “ Waste in Indus¬ 
try” is to lend the weight of engineering authority to the proposi¬ 
tion, already a matter of common knowledge, that if each concern 
would adopt the best methods which are already in use, making 
them standard practice, the result would be a great increase in 
efficiency. Even the best plants can learn at some points from 
their inferiors. 


478 


ECONOMICS OF OVERHEAD COSTS 


9. FAST AND SLOW WORKERS 

One other point must be at least touched upon, before leaving 
the topic of the relation of overhead costs to the productivity 
theory of wages. As between individual workers, wages are 
not gauged exactly according to their productive worth to the 
industry. A simple piece-wage would satisfy this test, if there 
were no overhead costs. But as it is, the slower worker keeps 
the same equipment busy with less output to show for it, and 
the only wage which would give the faster man his true relative 
worth would be a progressive price wage. Since industry in 
general does not follow this system, it does not give the fast 
worker his full differential worth as compared to the slower 
worker on the same job. It makes its wage-scales on the basis 
of giving the worker a stimulus and an incentive, so far as 
possible, to do his best, but not on the principle of giving him 
the full commercial value of his excess product. Industry 
shares it with him, under the usual piece wage, and hence makes 
a profit on his work, while in the long run it probably loses money 
on the slowest workers. 


10. CONCLUSIONS 

One conclusion which cannot be escaped, as one ponders the 
meaning of these and similar matters, is that our economic society 
is not put together by simple addition, nor is its income to be 
allotted by simple division. It is not a mechanical, arithmetical 
aggregate. The sum of the separate parts may be greater or less 
than the whole. After all the costs possible are charged against 
the business operations responsible for them, there remains 
an undistributed residuum for which someone is responsible. 
Demand and supply do not tend toward equality, and their 
discrepancies are themselves costs of industry, of which industry 
is just now awakening to a partial realization. All in all, the 
parts of our system are united, not by arithmetical addition nor 
by the mechanical composition of forces, but in that more 
thoroughgoing fashion characteristic of the parts of a true 
organism. Particularly is this true of all the different stages and 
movements of the business cycle, which is such an ever present 


LAWS OF VALUE AND DISTRIBUTION 


479 


fact that hardly any question of overhead costs can be thoroughly 
discussed without taking it into account. And it is of the very 
essence of the business cycle that no business works by itself 
or to itself. Whatever it does starts a series of reactions which 
ramify over the whole system, and return upon their authors 
in unexpected and unrecognized ways. 

And it is obviously a dynamic phenomenon. Most of the 
special significance of overhead costs is due to dynamic change 
in industry. But for this, size of plants and output would be so 
adjusted that constant costs would practically disappear, 
including even the costs of knowledge, for it is chiefly the knowl¬ 
edge of new things that is costly. Dynamic and organic—such 
are the dominant qualities of our modern economy of science, 
machines, and elastic credit systems. Its intricacies are baffling, 
especially to one whose previous notions of economic law have 
been largely confined to the static economics of more or less 
mechanical addition and division which we often imagine our¬ 
selves to have received from our ancestors—with what injustice 
to our ancestors we cannot now pause to inquire. A knowledge 
of the laws of overhead costs is not a master key to all the 
mysteries of our new dynamic-organic economy; in fact, there 
is no master key; but it opens many doors, and is one of the 
indispensable avenues of approach to a better and more systema¬ 
tized understanding of the things which static economics does 
not explain. In such a study, overhead costs are not exceptions 
to a general economic law: they are the general law. Dynamic 
economics must not merely take account of them, it must be 
built around them, for they are part of its essential framework. 


CHAPTER XXIV 

CONCLUSION 


SUMMARY 

The fool-proof machine and the superman economy, 480—Revolution by free 
contract, 482—Summary and retrospect, 483—Conclusion, 486. 

I. THE FOOL-PROOF MACHINE AND THE SUPERMAN 

ECONOMY 

The ideal of the maker of machines is well expressed in the 
phrase: “fool-proof.” This phrase describes a great deal more 
than a quality of a mechanism: it expresses an attitude toward 
the average man who uses it. An endless process of learning 
and growth by the method of trial and error—this is no part 
of the conception of life which the machine has for its attendants 
and beneficiaries. “So simple a child can operate it” is a most 
attractive motto, until one stops to think what it means to a 
mature mind to spend its working hours doing things a child 
could do. 

But at the same time, this race of machines, with their 
aspiration toward becoming fool-proof, has built up an economic 
system which in its larger aspects is the very opposite of fool¬ 
proof. In fact, it requires nothing short of superhuman qualities 
of vision, foresight, correlation and co-operation to make it work 
without disastrous break-downs. Of course the superhuman 
governing and correlating might be done by the superior few, 
leaving the many to lead their fool-proof lives as they will, but 
for one obstacle. Science and the printing-press have between 
them made democracy inevitable, economic as well as political, 
and therefore if social organization requires superhuman vision 
and powers of correlation, this vision must be grasped by the 
many and this correlation must be democratically conceived 
and brought into being. 

To be more specific, the problems of overhead costs are, 
above all things else, not fool-proof. The student cannot be 

480 


CONCLUSION 


481 


given a formula which will furnish an absolute answer to every 
question. He must use the highest grade of discriminating 
judgment if he is to distinguish case from case and to determine 
which rule applies or which policy is the most promising of 
results. The parrot which has been trained to repeat: “supply 
and demand” can no longer qualify as a competent economist 
nor even a fair caricature. 

The remedies for the wastes and misfits of overhead costs 
are many and difficult, especially as they require businesses to 
co-operate for certain purposes while competing for other pur¬ 
poses, until it is a wonder the typical business man does not 
get his economic roles hopelessly confused. The determining 
of a wise price policy during depressions, the merging of trade 
and industrial knowledge into a common fund, the handling of 
unemployment insurance, the building up of a body of trade 
ethics which will define harmful types of discrimination and 
condemn then—all these are co-operative functions. 

But always it seems to be organized business which bears the 
burden, initiative, and responsibility for these co-operative 
remedies, while the common man goes on his fool-proof way. 
Not quite, however, for his best faculties of thought and 
co-operation are needed to work out, discuss, and adopt a scheme 
of wage payment, soundly based on the facts of overhead costs 
and tending to give business an incentive to minimize idleness, 
instead of merely accepting the idleness as a foregone conclusion 
and attempting to keep wages high enough'to pay for it. For 
a wage policy which involves no increase in output can only 
raise real wages within very narrow limits, so long as private 
capital exists in anything like its present form. Increased 
money wages must inevitably be neutralized by increased 
prices, so long as the credit system will expand, and probably 
by lack of full employment after that limit has been reached. 
And even the taking of all socially unnecessary rewards now 
going to capital would not give the average laborer a thoroughly 
satisfactory income on which to raise a family. Individual 
trades may gain at the general expense, but labor as a whole will 
be trying to lift itself by its boot-straps. But a wage policy 


482 


ECONOMICS OF OVERHEAD COSTS 


which opens the door to increased output can pay for itself and 
bring larger real rewards to labor as a whole. 

And one of the steps most favorable to the development of 
such a policy is the establishment of a true relation of partnership 
between labor and the other parties in industry. Such a relation 
is well-nigh a necessity in order to make the employer and mana¬ 
ger appreciate the true bearings of labor’s overhead costs upon 
industry, and to make labor appreciate more fully the many 
conditions on which its own continuity of employment depends. 

Can the laborer, trained as a cog in a fool-proof mechanism, 
rise to this demand and meet these requirements? There is 
nothing for it but to hope most earnestly that he can, for if not, 
then one might as well admit frankly that the outlook for indus¬ 
trial civilization is dark. The individual must remain respon¬ 
sible for himself as fully as he is now: responsible for mastering 
his work and doing it well, for finding and keeping a job, and for 
giving the next generation that training in “gumption” and 
responsibility for which the best school is but a feeble instrument. 
But he must also bear responsibility for participating to his 
utmost, through his union and through other channels, in what 
is nothing less than the amending of the constitution of industry. 

2. REVOLUTION BY FREE CONTRACT 

One saving thing about such a rebuilding is that so much of 
it can be done by the use of the fundamental tool of the present 
system: free contract. The rights of property in industrial 
capital can be redivided and altered by this method, until by 
the time the new system becomes the “custom of the trade,” 
the courts would actually enforce it in the absence of specific 
stipulations. In this way changes can be voluntarily made which 
would be unconstitutional if government tried to bring them 
about by legislative order and compulsion. These contractual 
experiments might sometimes have to be tried on a large scale 
to insure success, though many are being tried on a small scale 
now. One of the most stimulating things in the study of over¬ 
head costs—one which most compels the imagination—is the 
fact that the content and behavior of such costs are governed by 


CONCLUSION 


483 


the form of industrial contracts. They differ from industry 
to industry as the result of differences in the forms of contract 
used and they are capable of being revolutionized by that non¬ 
revolutionary method. It is a very long process of education 
and experiment we have before us, and we cannot begin too 
soon, making the first of many mistakes and suffering the first 
of many discouragements. 

3. SUMMARY AND RETROSPECT 

Looking back for a moment over the course we have traveled, 
we may be able to gain a more general idea of the character of 
our journey. We have seen at the start that overhead cost is 
practically coextensive with unused capacity, and we have 
studied the various conditions governing the development of 
the capacities latent in the agents of production. We have 
seen how the idea of cost originates in certain purposes and 
depends upon the purposes it is to be made to serve; also that 
for certain purposes cost is not a mere present fact, but depends 
on the alternative offered. This is especially true of calculations 
of efficiency where the object is to minimize waste. We have 
also seen that the laws of “increasing return” and “decreasing 
return” need to be reclassified according to the unit in terms 
of which return is measured, and even more, according to the 
character of the “independent variable” at work, whether it is 
the growth of a plant, a change in utilization of an existing plant, 
or what not. We have seen how some of these independent 
variables operate, especially the many varieties of business 
rhythms. We have followed the life-story of an imaginary 
plant, sampling its problems of cost, and have wrestled with 
the difficulties of accounting allocation, statistical inference, 
and expert imputation. 

We have studied the special problems of railroads, finding 
that the traditional estimate of the proportions of constant and 
variable costs holds true for the seasonal cycle of traffic, but 
that for other purposes other estimates are needed. We have 
glanced at a few of the principles governing railroad discrimina¬ 
tions, and a few of the many criteria which would have to be 



484 


ECONOMICS OF OVERHEAD COSTS 


taken into account in attempting to base railroad rates on cost 
in a scientific fashion, so far as may be possible. We have 
studied the peak-load problem of the public utility industries, 
seeing how rates are made in systematic recognition of unused 
capacity; what sorts of classifications are used, the conditions 
and limitations imposed by public regulation. And we have 
seen how a definite policy of developing off-peak business may 
result in a greatly improved load curve and a new peak at a new 
time of day. 

We have very briefly surveyed industries as a whole, finding 
overhead costs to be universal, and discovering some of the 
characteristic symptoms in very marked form where we had 
least been led to expect them. Thus the non-shrinkable character 
of operating expenses appears very strongly in merchandizing 
while agriculture is seriously afflicted with the conditions natu¬ 
rally leading to cut-throat competition. There is a rough princi¬ 
ple of compensation whereby if an industry does not exhibit one 
aspect of overhead costs it will emphasize others. If fixed 
capital constitutes a small portion of its budget, materials may 
constitute a large one, raising difficulties because they are 
“sunk costs,” irrecoverable in time of depression, and if neither 
is present and production is on a small scale, this very fact 
involves a waste of the “intellectual overhead” and a corre¬ 
sponding need for co-operative organization or public aid in order 
to give the industry the benefit of adequate trade and technical 
knowledge. 

We have seen that overhead costs exist in consumption, 
and that the ultimate human costs of labor contain a large 
element of overhead, which the community must bear if the 
laborer cannot successfully finance it. We have seen how over¬ 
head costs act during the business cycle, both as cause and as 
effect—how the concentrated purchases of capital goods act 
as a disturbing element, how the accounting that should record 
the waste of idleness and the need of full production fails to do 
so, because overhead costs are converted into direct or variable 
costs by the mechanism of the market in the process of purchase 
and sale. We have seen how business is awakening to a realiza- 



CONCLUSION 


485 


tion of this fact and even beginning to think and speak of “ social 
cost-keeping”—a form of economic reckoning which cuts through 
the sophisms of private financial accountancy and calls social 
waste by its true name. 

We have noted the altered principles of responsibility which 
true social cost-keeping carries with it, as compared to the 
individualistic canons of responsibility to which business is 
accustomed. We have seen that to a certain extent opportunity, 
means responsibility; that the person who benefits by a given 
process, and has power to alleviate evil conditions which result 
from that process, has a real obligation to do so, regardless 
whether this is contained in the letter of his contractual stipula¬ 
tions or not. For he is not a member of society by force of 
contract, older opinions to the contrary notwithstanding, 
and his social obligations are rooted deeper than any form of 
mere business agreement. The principle of social responsi¬ 
bility is virtually identical with the principle of incentive/ 
distributing burdens in whatever way may do the most good in 
stimulating those who can to reduce the wastes of industry. In 
the light of these principles of rudimentary social accounting 
we have briefly reviewed the proposed remedies for the business 
cycle, and have concluded that the cure of this great evil is 
within the realm of economic possibility. 

We have studied the character of markets and of discrimi¬ 
nation, with the many forms it takes and the varied purposes 
which lie behind it, seeing in it an engine of social efficiency, 
a tool of predatory warfare and oppression, a means alike of 
personal favoritism or of higher equity, and sometimes the result 
of sheer ignorance or negligence. We have examined cut-throat 
competition, the nature and sufficiency of the checks upon its 
action, and the forms of potential competition which survive 
when active competition has been largely suppressed. We have $ 
found that price is not the result of absolutely uncontrollable 
forces, but that a considerable measure of discretion exists in 
the choosing of price policies and enforcing them. This appears 
to be rather a source of encouragement than otherwise, provided 
this discretionary power can be guided, harnessed, or otherwise 



486 


ECONOMICS OF OVERHEAD COSTS 


directed toward the type of policy which the principles of over¬ 
head costs indicate as most appropriate to the steadying of 
industry—meaning the steadying of production, not of prices. 
For, as we have also seen, the absolute steadying of prices is an 
inappropriate remedy, especially with such an industry as steel, 
where conspicuous experiments in that direction have been 
tried. 

Finally, we have glanced at the productive services of govern¬ 
ment and the “ factors of production” which it furnishes, viewing 
them as forms of social overhead, identical in character with 
some which private industry regularly bears in its own budget. 
Last of all, we have seen how overhead costs affect the laws by 
which the produce of industry is apportioned among the contrib¬ 
uting factors, making it impossible for each to get its full differ¬ 
ential contribution, since the sum of them all would absorb 
more than the whole product of industry, so that the variable 
factors must endure a deduction from their “ marginal product” 
if the constant or overhead factors are to get any reward at all. 
And we have seen that in a study of dynamic economics, over- 
n head cost must be regarded, not as the exceptional circumstance, 
but as the typical case and one of the central subjects of study. 

In covering such a wide range of fact and principle, much 
has necessarily been left to the reader’s own sense and insight, 
many important subjects have been necessarily dismissed with 
a brevity which would be regrettable, save that otherwise this 
range of material could not be placed before the reader at all, 
in its logical unity and organic coherence, and some things 
have been reiterated, because they appeared in more than one 
connection and none of these connections could fairly be ignored. 
We have to deal with a body of principle, not a series of discon¬ 
nected problems, and every effort has been made to present it in 
this light. 

4. CONCLUSION 

So, at the end, without further apology, we may end our 
study with a curious wonder at the intricacies of the financial- 
economic machinery which man has built. Man did not design 
them; they are rather the unintended by-products of the inven- 


CONCLUSION 


487 


tions which he did design to serve his supposed needs. These 
unintended by-products he does not even understand. They 
appear with all the force of living things with purposes foreign to 
those of mankind, because they act in ways which man does not 
understand and did not plan. No man has yet comprehended 
them completely. Yet we do know enough to offer some pros¬ 
pect of controlling them, though we must well-nigh remake our¬ 
selves and our industrial organization in the process. And so we 
may look forward, not without hope, to the task of taming the 
New Leviathan. The stakes are heavy, for if we do not tame 
him, he may devour us. 












INDEX OF AUTHORS 

Names followed by asterisk (*) indicate valuable supplementary readings on the problem of 
overhead costs. 


Acworth, W. M.,* on division of labor 
on railways, 123 

Adams, Henry, on the expansion of the 
use of power, 107 

Atkins, Paul,* on variable costs, 54; 
on regularization of seasonal produc¬ 
tion, 162, 166 

Ayres, Leonard P., on statistics of 
motor transport, 299, 300 

Baker, Charles Whiting, on haulage 
costs by road, 109; on costs of high¬ 
way transport, 308 

Barker, H. G.,* on size and cost in 
gas plants, 320 

Bibbins, J. R., on total investment in 
transportation, 299, 300 

Brown, Harry G.,* on sunk costs, 54; 
on roundabout haulage by rail, 294 

Bruere, Martha Bensley,* on dove¬ 
tailing seasonal demand for farm 
labor, 152 

Calder, John,* on guaranty of weekly 
wage at packing-houses, 379-80; on 
handling unemployment, 383; on 
private vs. public action to cure 
unemployment, 411 

Caracristi, V. Z., on economy of size 
in railroad repair facilities, 266 

Carver, T. N.,* on laws of return, 71, 73 

Clark, J. B.,* on relation of prices to 
costs, 13; on discrimination as 
unfair competition, 424; on potential 
competition, 444 

Coal Commission,* 348 

Cobb, C. W., on whole product and 
marginal contributions of factors of 
production, 473 

Davenport, H. J.,* on opportunity 
costs, 49, 186; on laws of return, 71 

Dennison, Henry S., on economy of 
regularization, 380-81, 383 

Dewing,* on economics of combination, 
146 

Dewsnup,* on joint costs, 59, 80 


Dibblee, G. B.,* on selling expense as 
overhead, 60 

Douglas, Paul H., on employment 
during depressions, 51; on output 
of labor in dull times, 93; on regulari¬ 
zation in the Columbia Conserve 
Co., 371; on personnel work, 133 

Douglas, Paul H., and Dorothy, on 
overhead costs in consumption, 355 

Draper, Ernest G., on economy of 
regularized production, 372 

Dudley, E. W., an example of proportion 
of factors, 74 

Edgeworth, F. Y.,* on joint costs, 59, 80 

Federal Trade Commission, on interest 
as a cost, 66 

Federated American Engineering Socie¬ 
ties,* on waste in industry, 183, 352, 
477 

Field, A. S., on construction of express 
rates, 291 

Fisher, Irving, plan for stabilizing the 
dollar, 412 

Flux on whole product and sum of 
marginal contributions, 473 

Frazer, C. E., on elasticity of merchan¬ 
dising expenses, 339. 341, 343 

Gantt, H. L.,* on standard burden 
rate as measure of cost of idleness, 
250, 253 

Hadley, A. T.,* on economic conse¬ 
quences of constant costs, 12; illustra¬ 
tion of rates on oysters, 214 

Haney, L. PI., on integration in market¬ 
ing, 139 

Hansen, A. H., on materials as sunk 
costs, 339, 448 

Hapgood, W. P., on employees’ prefer¬ 
ence for longer day and five-day 
week, 360; on regularization, 370-71 

Harvard Bureau of Business Research, 
121, 339, 342 

“Hoover Committee,”* on waste of 
technical knowledge, 183, 352, 477 


489 


490 


ECONOMICS OF OVERHEAD COSTS 


Hoyt, Homer,* on standardization, 97 

Hull, George H.,* on relation of 
construction to business depressions, 

389 

Illinois Coal Operators’ Association, 
on workers’ irregularity in coal 
mining, 348. 

Interstate Commerce Commission, Sta¬ 
tistics of Railways, no, 261, 270; 
bulletins of employees and compensa¬ 
tion, 277, 279; monthly net earnings, 
279; ruling against unremunerative 
rates, 281; on estimates of terminal 
costs in Boston, 289; on excess of 
coal mines, 348 

James, William, on human reserves, 358 

Jenks, Jeremiah, 95, 96 

Jones, Eliot,* on economies of combina¬ 
tion, 147; “Is competition ruinous?” 
447 

Jordan and Harris,* definition of cost 
accounting, 233 

King, W. I.,* on employment, 18, 
372-74, 399; on unemployment in 
large and small concerns, 130; in 
merchandising, mining, transport, and 
manufacturing, 341 

Knauth, Oswald,* on relation of invest¬ 
ment to product in manufacturing, 
338 . 

Kotany,* on size and efficiency, 114, 
115, 131, 190 

Lardner, Dionysius,* system of allocat¬ 
ing railroad expenses, 10 

Launhardt, W., statistical method of 
allocating costs to freight and 
passengers, 226 

Lee, Gerald Stanley, on benefits of 
monopoly, 142, 143 

Leverhulme, Lord,* on the six-hour 
day, 7 

Lewis, Sinclair, 96 

Lincoln, Paul M., on tendency of 
investment to increase faster than 
operating expenses, 113; on econ¬ 
omies of size in electrical power, 
318-19 

Lorenz, M. O.,* on constant and 
variable expenses, 52; on composite 
units of railroad traffic, 211; on 
railroad traffic density and costs, 
265, 267-70 


Lyon, L. S., and L. C. Marshall,* 
on constant and variable costs, 52; 
advantages of combination, 95; of 
size, 126 

Marshall, Alfred,* on “spoiling the 
market,” n; on “representative 
firm,” 13; on the drawbacks of size, 
189 

Marshall, L. C., and L. S. Lyon,* on 
constant and variable costs, 52; 
advantages of combination, 95; of 
size, 126 

Martin, Winthrop, on railroad morale, 

125 

Marx, Karl, on overhead costs and long 
hours, 6-7 

Mason, A. J., on wastes in coal mining, 
352 

Massachusetts Department of Labor, 
figures on unemployment, 372 

Mill, John Stuart,* on joint costs, 5, 59 

Mitchell, W. C.,* on unemployment in 
large and small concerns, 130; on 
business cycles, 386-87, 389, 436 

Moore, H. L., on climatic changes and 
the business cycle, 388 

Morrow, J. D. A., on coal rates and 
distance in the South, 292 

National Association of Cost Account¬ 
ants,* on standard burden rates, 252 

National Electric Lighting Association 
Committee on Prime Movers, objec¬ 
tions to too few large generating 
units, 320 

Nerlove, S. H., on monthly fluctuations 
of employment on railroads, 277, 279 

New York Superintendent of Public 
Works, on New York canals, traffic 
and costs, 316 

Nimmons, study of most efficient height 
of office-building, 227 

Northwestern University, Bureau of 
Business Research, Survey of Retail 
Distribution of Clothing, 343 

Nourse, E. G.,* on overhead costs in 
agriculture, 344, 346; on labor 

incomes from farms, 447 

Noyes, H. T., on planning for expansion, 
104, 119 

Owers, J. C., on costs of terminal 
freight movements in the Boston 
district, 289 



INDEX OF AUTHORS 


491 


Pigou, A. C.,* on joint costs, 59; on 
the dilemma of unused capacity, 449 

Putnam, G. E., on unit costs as guides 
to buying, 436 

Redfield, on standardization, 96 

Ripley, W. Z.,* formula for constant 
and variable costs on railroads, n, 
51-52, 94, 228-30, 258-59, 274; on 
overloaded combinations, 145; on 
waste of roundabout rail carriage, 294 

Rowntree, B. S.,* on regularization, 383 

Sakolski, A. M., on the Virginian Rail¬ 
road, no 

Seager, Henry R., on unemployment 
vs. vacations, 157 

Seligman, E. R. A.,* on joint costs, 59 

Senior, on constant expenses and hours 
of work, 6-7 

Smith, Adam, on division of labor, 105, 
106, 107, 140 

Stewart, W. W.,* on need of maintain¬ 
ing both price and output, 406; on 
need of co-operative organization, 411 

Taussig, F. W.,* on joint costs, 59; 
“Is market price determinate ?” 427; 
on “spoiling the market,” 443 

Taylor, F. M.,* on law of diminishing 
return, 70, 72, 86; on plant utilization, 
89; on efficient size of plants, 96 

Titsworth, H. H., on wastes of piecemeal 
expansion, 104, 119 


Torrens, on constant costs in relation to 
business fluctuations, 6, 89 

United States Bureau of Mines, 121 

United States Commissioner of Labor, 
figures on unemployment, 372 

United States Department of Agricul¬ 
ture, on costs of road-haulage, 109; 
an example of industrial research, 
121; benefits of improved highways, 
309 

Van Hise, Charles R.,* on economics 
of combination, 147 (footnote begin¬ 
ning p. 146) 

Viner, Jacob,* on dumping in interna¬ 
tional trade, 420 

Walker, Francis, on interest as a cost, 66 

Wallis, Percy, and Albert, on amount 
of unemployment, 372 

Watkins, G. P.,* on load and capacity 
factors, 15, 79; on electrical rate 
systems, 324-25, 327; on salaried 
class, 370 

Weld, L. D. H., on intensive cultivation 
of a market, 130; on integration in 
marketing, 139 

Wicksteed, P. Y.,* on whole product 
and sum of marginal contributions of 
factors of production, 473 

Williams, C. B., 50; an instance of 
“spoiling the market,” 442 

Wisconsin Railroad Commission, figures 
of cost and size of public utilities, 
320-21 


INDEX OF SUBJECTS 


Abandonment costs, 55, 180, 200-201; 
see also Cost: receiver’s standpoint 
on, Abandonment: Aetermining the 
point of, 333-34 

Accounting: cost of materials, 197; 
financial charges vs. costs of pro¬ 
duction, 40-41, 176; private vs. 

social, 27-30, 415; see also Allocation 
of costs, Cost-accounting, Financial 
accounting, Income determination, 
Interest as a cost, Social cost-keeping 

Adaptation to industrial progress, 122 

Agriculture: economies of size, 346-47; 
load factor, 346; overhead costs in, 
343-47; seasonal character, 151; 
seasonal unemployment, 373 

Allocation of costs: 14, 186; of labor’s 
overhead, 381; by the market, 372; 
methods of, 216-27, 231; see also 
Costs: allocation of; Responsibility 

American Steel Hoop Co., gains by 
standardization, 96 

Assessing and collecting overhead costs, 
3 i- 34 , 302-3 

Associated Charities of Cleveland, 376 

B. & O. R. R., coal consumption, winter 
vs. summer, 275; cost-fluctuations, 
270-71 

Back loads for freight cars, 100 

Banks, influence accounting practice, 
68, 241 

Bargaining advantages, 82, vs. pro¬ 
ductive efficiency, 122, 127-28 

Bituminous coal mining, 151, 168; 
problem of regularization, 161, 347-52 

Bonded indebtedness, 448 

Booms and depressions, see Business 
cycle 

Brands of goods and allocation of costs, 
186 

Building ahead of demand, 134, 189, 
323; idle overhead resulting, 330-32; 
cf. “Wisconsin principle,” 332 

Burden: standard rate, 65, 243, 251-54; 
effect on meaning of “cost,” 252-54; 
as solvent for labor unrest, 254; and 
unabsorbed burden, 243, 251-52, 403 


Bureaucracy in industry, 125, 141 

Business cycle, n, 24, 91, 127, 152, 156, 
164-65, 170, 363, 374, 386-415; buy¬ 
ing more on a rising market, 396; 
causes of, 387-97; concentration of 
capital expenditures, 389-96; con¬ 
fidence, 412-13; conservative and 
radical views of, 119; credit system 
and, 396, 408; cumulative forces at 
work, 388-89, 393-94; efficiency in 
relation to, 18, 27-28; employment 
offices, 412; financial inflation, 396, 
408; observed facts, 389; post- 
ponable expenses, 389-90; private 
construction, 408; psychological ele¬ 
ment, 407; public works, 410; 
remedies, 400-401, 407-13; remedies 
cumulative, 413; results of curing, 
413-14, 448; shrinking sales by 

shrinking purchases, 400-401; stabi¬ 
lized dollar, 412; statistical indexes, 
412; unassimilable growth of pro¬ 
duction, 408; unpredictability, 155, 
396-97 

Business rhythms, 149-74; benefits of 
moderate irregularity, 156-57; cli¬ 
mate and custom as joint causes, 154; 
compensation for, 171-72; methods 
of control, 159-61; predictability, 
155 

Buying: advantages of integration, 137; 
bargaining advantages vs. productive 
efficiency, 127-28; co-operatives un¬ 
able to buy as retailers, 139; econ¬ 
omies of size, 82, 121-23; of hori¬ 
zontal combination, 141 

By-products, see Joint products 

Capacity: elastic, 260; in excess of 
demand, 134, 168, 189, 347-48, 414, 
439; of equipment, 109, 118; of 
factors of productions, 72-73, 76-78; 
of a plant, 90-91, 112, 118, 183; of a 
ship, 115; oversupply of, tendencies 
toward, 439; points of congestion, 
118; semi-obsolete plants, 438; short- 
run fluctuations limited by, 259; 
supply of, 437-39 

Capacity costs: in public utilities, 323; 
on railroads, illustrative problem, 
284-85; responsibility for, 326-28 


492 


INDEX OF SUBJECTS 


493 


Capacity factor of a plant, 79, 94; in 
illustrative case, 184-85, 187-88 

Capital expenditures: concentration of, 
389-96, 406, 415; regularization of, 
409 

Carnegie Steel Co., 95 

Casual labor, 371, 376; employer’s 
responsibility, 409; see also Casual 
work 

Casual work: burden concentrated, 368; 
makes casual workers, 368 

Charging what the traffic will bear, 281, 
293, 324, 330; in the case of labor, 
378; see also Differentiated rates, 
Discrimination 

Charity: bears cost of unemployment, 
376 

Checks and balances a result of size and 
monopoly, 125, 131 

Chemical production, 106; diminishing 
return in, 73; continuous processes, 
117 

Christmas shopping peak, 155 

Clearing-house for labor, 158, 160, 382; 
see also Employment offices 

Cleveland Ladies’ Garment Industry 
guarantees minimum employment, 
380 

Coal mining, 168; and central power 
stations, 352; excess capacity, 347- 
48; idle overhead, 347; labor as an 
overhead, 349-52; regularization, 
161; seasonal character, 151; utiliza¬ 
tion of known methods, 352 

Columbia Conserve Co. and regulariza¬ 
tion, 370-71 

Combination: economies of, 135-48; 
horizontal, 81, 141-42; limited by 
organizing power, 117; vertical, 81, 
i 35 j 13M1 

Community vs. business view of cost 
and efficiency, 19-22, 167-70, 182-83, 
352, 384-85, 399 - 403 , 4 i 3 , 415 , 462; 
effect of integration, 403 

Competition, 82; between sections, 291; 
bidding for means of production, 436, 
461-62; cut-throat, see Cut-throat 
competition; outposts of, 445; per¬ 
sists in qualified form, 423, 435, 461; 
potential, 444-47, 461; theoretical, 
441; tolerated fringe of, 440; waste 
when limited by agreements, 446; 
wastes of, 82 

Complementary products: see Joint 
products 


Concentration: geographical, 82-83; of 
purchases, 154, 389-96 

Congestion: sets limit on utilization, 

259 

Constant costs: converted into variable, 
25-26, 338, 340, 387, 397 - 401 , 462; 
cf. 402-3; dependent on forms of 
contract, 27, 91-92, 384, 462, 482-83; 
expansion of, 43-44, 85, 104-5, 

107-10, 112-13, 119, 224, 258-59, 
262-63, 269-70; vs. “fixed charges,” 
40-41, 46-47, 220-21; in an integra¬ 
tion of universal scope, 402-3; in 
operating expenses, 265-69; Ripley’s 
formula, n, 51-52, 94, 228-30, 258- 
59, 274; and variable costs, 51-54 

Consumption: economies of size, 355; 
overhead in, 354-55; spare-time 
work, 354 

Continuous processes, 117, 172 

Contract, 195-96, 248, 341, 397; form 
of, affects apparent volume of con¬ 
stant costs, 27, 91-92, 384, 462, 482- 
83; revolution by, 482 

Conversion of constant into variable 
costs and vice versa, 25-27, 30, 338, 
340, 362, 387, 397-4 oi; cf. 402-3 

Co-operation and competition: mixed 
roles, 481 

Co-operative activities in business, 29- 
30, 83, 123, 160, 162, 210, 231; in 
agriculture, 346-47; in consumption, 
355; in handling unemployment, 383; 
informal control over competition, 

404 

Co-operative organization to meet the 
business cycle, 411-12 

Cost accounting, 14, 36, 45: allocation, 
methods of, 216-17, 218-22, 231-49; 
burden, 65, 243, 251-54, 403; con¬ 
ception of cost, 49, 64-65; and cost 
analysis, 67, 232-33, 256; data re¬ 
quired, 244-45; and financial ac¬ 
counting, 36, 66-67, 181, 218, 233; 
ten purposes of, 234-44; and valua¬ 
tion of inventory, 68, 241; see also 
Costs: allocation 

Cost analysis, 67-68, 232 

Cos.t: and alternatives, 37-38, 182, 186, 
202; average of fluctuations, 187-88; 
as basis of rail rates, 290-93; differ¬ 
ential, 47-50, 56, 128, 167, 169, 176, 
182, 185, 194-98, 203, 204, 208-10, 
238, 243-45, 251, 280, 292-93, 421, 
434-35, 441; depends on size of 
unit, 213-14; of one sale vs. a 
policy, 214-15; and the statistical 


494 


ECONOMICS OF OVERHEAD COSTS 


method, 223-37; and price of added 
business, 324-30, 416, 448; of work 
vs. unemployment, 360; of labor to 
laborer, 356-66, 384; vs. to the 
employer, 378-79; 
economists’ standpoint on, 181; engin¬ 
eers’ estimates, 189; joint cost, 58-59, 
in integration, 137; see also Joint 
products 

manufacturing vs. selling, 59-63; 
of holding materials vs. working 
them up, 197; see also Materials; 
of idleness, 217, 242, 250-54; re¬ 
ceiver’s standpoint, see Costs of 
abandonment; unpaid services in¬ 
cluded, 187; see also Costs 
Costs: of abandonment, 55, 180, 199, 
200-201; absolute vs. alternative, 

37- 38; see also Cost and alternatives; 
allocation: methods of, 38-39, 57-58, 

61, 216-31; to a period, 204-6, 
225-26; to products, 206-10; by 
accounting method, 207-8; by 
statistical method, 208-10; of all 
costs vs. differential costs only, 
208-10, 222, 287-88; by hypo¬ 
thetical experiment, 228; to weath¬ 
er and to traffic, 230; to depart¬ 
ments, 241-42; of overtime, 246- 
47, 249; difficulties of causal 

tracing, 247; on railroads, 287-88; 
of costs of quality, 329; a matter 
of judgment, 330; by the market, 
372; of labor’s overhead, 381; see 
also Community vs. business view 
of costs; Responsibility, Social 
cost-keeping; 

as basis for prophecy, 237-38; con¬ 
stant and variable, 51-54, 175, 182, 
224, 279, 312, 398-99; see also Con¬ 
stant costs, variable costs, differen¬ 
tial and residual, 49-50, 56, 128, 
167; see also Cost, differential, 
differential costs, residual costs; 
direct, 246-49; an index of differential 
costs, 210, 245, 253; and indirect, 

38- 40, 56, 203, 242, 249-55; eco¬ 
nomic force of wrong conceptions, 45; 
in handicraft or domestic system, 2; 
as legal obligations, 178; long vs. 
short variations, 43-44, 85, 105, 107- 
10, 113, 259, 282, 323; marginal vs. 
bulk-line, 13; minimum, 48-54; and 
prices, 39, 64-65, 97, 167, 234-36, 
237-39, 242, 256; costs of production 
vs. financial charges, 40-41, 176; 
shut-down costs, 54, 182, 199; sunk 
costs, 54-55, 180, 197,. 239, 339, 341- 
43, 345; ultimate sacrifices, 178, 181; 
urgent vs. postponable, 55, 92-93; 
various views of, 35-36, 181, 189; see 


also Constant costs, Cost, Differential 
costs, Direct and indirect costs, 
Residual costs, Variable costs 

“Cracking” of petroleum, 98-99 

Crop rotations, 98-99 

Cross-freights, saving of, 81-82, 97, 
142 

Cumulative forces in business, 388-96, 
406; work in both directions, 413 

Cut-throat competition, n, 28, 84, 103, 
167-68, 179, 434 - 50 , 447 - 48 , 469, 
474; in agriculture, 345; effect of 
bonded debt, 448; of labor, 378; on 
a rising market, 436; unnecessary as 
stimulus to utilization, 449 

Damage to highways, 303, 305-6; 
see also Depreciation 

Decisions and precedents as overhead 
assets, 124, 128 

Delegated detail, 123-24 

Demand: causes of fluctuation, 407; 
dependent on supply, 467; maximum, 
126; see also Peak load 

Demand: fluctuations of, due to fluctua¬ 
tions of incomes, 407; obligation to 
maintain, 466-67 

Demand and supply: cumulative ac¬ 
tion, 389, 413; derived demand, its 
intensified fluctuations, 390-96, 406; 
discrepancies, 374, 465-67, 478; as 
guide to economic efficiency, 463-64; 
two sides of one thing, 467 

Dennison Manufacturing Co., joint fund 
for unemployment, 380-81 

Departmental specialization, 123-24; 
goals distinct from those of the in¬ 
dustry as a whole, 126 

Departments: allocation of costs to, 
241-42, 254-55 

Depreciation, 55: involves prophecy, 
222; of good-will, 62; of highways, 
3°o, 303, # 305-6, 3io, 317; of 

motor vehicles, 300; of railroads and 
waterways, 315 

Depression, 179, 198; see Business cycle 

Deterioration of highways, see Deprecia¬ 
tion 

Differential cost, 49-50, 56, 128, 167, 
169, 176, 182, 204, 208-10, 238, 243- 
45, 251, 280, 292-93,421, 434-35,44i; 
depends on size of unit, 213-15; of 
labor to laborer, 356-66, 384; to 
employer, 378-79; of labor vs. un¬ 
employment, 360; and price of added 
business, 324, 330, 416, 448; statisti- 
cal^tracing of, 223-27 


INDEX OF SUBJECTS 


495 


Differentiated rates, 318; limits on, 323; 
see also Discrimination, Prices 

Dimensions of business, '22 

“Diminishing return”: intangible fac¬ 
tors exempt, 120; law of, 70-71; for 
society as a whole, 83; one stage of 
the law of proportion of factors, 87-88 

Direct and indirect costs, 38-40, 56, 
203, 242, 249-55 

Discrimination, 2, 4, 103, 281-82, 416- 
33, 434, 469; between commodities, 
428-30, and services, 430-31; between 
localities, 423-25; classes of buyers, 
425-28; collateral services, 431-33; 
discounts for cash, 427; efficiency 
and, 416; general principles, 293-95; 
justice vs. expediency, 163; and 
mores of business, 167; off-peak 
business developed by, 23; in prices 
vs. selling efforts, 170; professional 
fees, 428; on railroads, 9-11; retali¬ 
atory, 424; seasonal, 285-86; trade 
perquisites, 428; in wage-rates, 378; 
weapon of trade discipline, 424; see 
also Charging what the traffic will 
bear, Differentiated rates, One-price 
system 

Dismissal, penalty for, 381 

Distance: as limiting economies, 118, 
120, 129; and railroad haulage costs, 
289-90 

Diversity factor, 126 

Dividends: during lean seasons, 155; 
see also Income determination 

Division of labor, 105-6, 123; in work 
of management, 123-25 

Dovetailing different kinds of work, 98, 
157 , 160, 349, 364-65; see also Off- 
peak business 

Dumping, 178, 194, 420-23; evidence 
of concerted action, 422-23 

Dynamic character of problems of 
overhead cost, 479 

Economist’s view of costs, 37 

Efficiency: apparent vs. real, 272-73; 
economic vs. technical, 70-71; of 
industry in the large, 463, 466; loss 
of, 109; see also Community vs. 
business view of cost and efficiency, 
Social cost-keeping 

Electric current: capacity cost, 219-20; 
consumer costs, 195; developing off- 
peak business, 162-63; periodicity, 
149-50; uses of, 101 

Electrical plants: economies of size, 
318-20; rate systems, 316 


Emergencies and routineers, 124-25 

Employment offices: co-ordination of, 
412; cf. also 382; see also Clearing¬ 
house for labor 

Engineer: estimate of economy of size 
in railroad repair facilities, 265-66; 
view of costs, 36, 181, 241; of worth 
of productive factors, 471 

Equipment: adjusted to output, 107- 
10; overequipment, 110-12; requires 
long look ahead, 190-91; scrapping 
of, 192 

Expenses, see Costs 

Experimentation, an advantage of size, 
119 

Express rates and distance, 291-92 

Extensive cultivation, 89; see also 
Proportion of factors 

External economies of large-scale pro¬ 
duction, 82-84 

Factory production: basic economies 
of, 105 

Farming: dovetailing with other oc¬ 
cupations, 160; overhead costs in, 
343-47; seasonal character, 151-52; 
unemployment, 373 

Fatigue of labor, cumulative fatigue, 
359; physiological fatigue a constant 
cost, 361; reserves of power, 358-59; 
second wind, 356; sensation vs. 
physiological fact, 356-59 

Fear of discharge as incentive, 8, 368-69 

Federal Reserve System, 411; and con¬ 
trol of financial inflation, 408; a 
model for other industrial fields, 457 

Federal Trade Commission, 417 

Financial accounting, 36, 66-67, 181, 
218, 233; not causal allocation, 218; 
and cost of materials, 197 

Financial charges vs. costs of produc¬ 
tion, 40-41, 176 

Financing: advantages of size, 131; of 
burden of unemployment, 376, 378, 
380-81; of costs of government, 
454-55; .of modern highways, 303-5; 
of stabilization of employment, 410 

Fixed charges, 46; vs. constant costs, 
40-41, 46-47, 220-21 

Fixed expense, 108; see also Constant 
costs 

Flexibility in equipment, 117, 118; see 
also Fluctuations 

Fluctuations of business: benefits of, 
156-57, 273; compensation for, 171- 
72; effect on average costs, 187—88; 


496 


ECONOMICS OF OVERHEAD COSTS 


intensified, 390-96, 406; see also 
Business cycle, Business rhythms, 
Seasonal fluctuations 

Fluctuations of utilization, 91-95, 98, 
184-85, 461; affects meaning of “sup¬ 
ply,” 464; burden of, 377; mercantile 
costs and, 340-41; see also Peak load 

Fool-proof machines vs. complex eco¬ 
nomic system, 480-81; laborer a 
cog, 482 

Ford Motor Co., 93 

Foundry patterns, 118 

Functional specialization, 123-24 

Gas: storage affects peak demand, 149- 
50; consumer costs, 195 

Gas plants: economies of size, 320-21 

Germany finances work for the un¬ 
employed, 410 

Government departments: costless in¬ 
vestment, 354; overhead in, 352-54; 
should interest be counted? 353-54; 
works of unemployment relief, 354 

Government as an overhead cost of 
business, 337, 451-58, 463; bases of 
allocation, 454-55; costs outgrowing 
methods of finance, 454, 458; as 
economic agency, 4S3~54, 45$, 463; 
measurement of benefits, 455-56; 
services analogous to business, 452- 
53; taxing special benefits, 456-57; 
uncompensated costs of industry, 457 

Great Lakes, 302 

Handicapped workers and overhead 
costs, 367-68, 478 

Haulage: cost by road and rail, 109 

Highways, 298-300; benefits measured, 

309- 10; budget of, cf. Railways, 300; 
competition with railways, 307-9; 
construction as unemployment relief, 

310- n; co-ordination between way 

and traffic, 302-6; depreciation vs. 
amortization of bonds, 310; economic 
surveys, 302; economy of full use vs. 
undue damage, 304-5; emergency 
use in case of rail strikes, 309; fi¬ 
nancing, 303-5, 307; overhead 

costs, 21-22; responsibility for de¬ 
terioration, 305-6; revolutionized 
by motors, 303 

Horizontal combination, 81, 135, 141- 
42; economies of, 146-47 

Human capacity best developed by 
varied work, 358 

Human economy and overhead costs, 
356-66, 462-63; alternative costs, 


360, 364-65; cost of unemployment, 
360; human depreciation, 361-62; 
human maintenance an overhead 
cost, 361-62; idleness as unabsorbed 
burden, 403; physiological cost of 
labor, 359; training as a human 
investment, 362-63 

Idle overhead, 14, 15, 386, 415; benefits 
of, unused capacity, 160; of labor, 
367-68, 402-3; see Cost of idleness 

Idleness: defined, 402 

Incentives: as basis of assessing over¬ 
head costs, 32-34; fear of discharge, 
8, 368-69; rate regulation and 

efficiency, 332-34; to regularization, 
371, 384, 405, 411, 467; necessary if 
labor owned industry, 402 

Income: determination of, 178, 181, 
192-94; and valuation of inventory, 
239-40; see also Financial accounting 

“Increasing return”; law of, 70-71; a 
stage of the law of proportion of 
factors, 86, 89; see Size of plant, 
economies of; Combination, econ¬ 
omies of 

Indirect costs, 38-40, 56, 203, 242, 249- 
55 

Inducements, 405; see Incentives 

Industrial pioneering as social overhead, 
84 

Industrial research, an advantage of 
size, 119; need of community organi¬ 
zation of, 123; one-sided, 122; see 
Intellectual overhead 

Industrial reserve army, 366; private 
vs. unified reserves, 382; see also 
Unemployment 

Inelastic demand an obstacle to de¬ 
veloping off-peak business, 170 

Inertia to be overcome in regularizing 
industry, 163 

Inland waterways, 302, 311-16; eco¬ 
nomical depth of channel, 313-14; 
effect on rail rates, 316; errors in 
calculating overhead, 312; New 
York Barge Canal, 315-16; terminal 
costs, 314 

Insurance: as a conversion of variable 
into constant costs, 30; large con¬ 
cerns carry their own, 126-27 

Insurance against unemployment, 381 

Intangible overhead, see Intellectual 
overhead 

Integration, 24-25, 81, 136-41; de¬ 
pendent on size, 139; economizing 
knowledge, 137; of all industry: 


INDEX OF SUBJECTS 


497 


effect on overhead costs, 402-3; 
and monopoly, 135; regularized re¬ 
newals, 137-38; reliability of mate¬ 
rials, 137; “two profits,” 136; cf. also 
408-9 

Intellectual overhead, 119-22; decisions 
and precedents as forms of, 124; 
financing of, 476; integration, 141; 
knowledge of the market, 369-70; 
need of making it a free good, 477; 
obsolescence of, 122; see also in¬ 
dustrial pioneering. Industrial re¬ 
search 

Intensified fluctuations: law of, 390-96, 
406; limits on, 393-94 

Intensive cultivation, 89; of a market, 
130; see also Proportion of factors 

Interdependence makes business an 
organism, 403 

Interest as a cost, 42, 65-67, 175, 221, 
239-40, 244-45, 2 5S-5 6 ; abandon¬ 
ment and, 200; hypothetical case, 
184-85; rate of, 43, 187; variations 
of, 42 

Internal economies, 82-84; see also 
Size of plant 

Interstate Commerce Commission, 316, 
426 

Inventory: control of, 237, 239; valua¬ 
tion of, 237, 239-40 

Investment as a constant cost, 259, 399; 
growth of, 113, 190, 262-63, 3 r 9 

Iron Slave, 8-9, 77-78, 106-7, 171, 
172, 391; see also Machines vs. 
laborers, New Leviathan 

Joint products and joint costs, 23, 58-59, 
80, 84, 98-103, 398; and economies of 
size, 102-3; and horizontal com¬ 
bination, 142; and integration, 137 

Justice vs. expediency in discrimina¬ 
tions, 163, 173, 286, 325 

“Key men” as an element of constant 
cost in wages, 184-85 

Knowledge as an overhead cost, 119; 
exempt from diminishing returns, 120; 
financing of, 476; in integration, 141; 
of the market, 369-70; need of mak¬ 
ing it a free good, 477; see also In¬ 
dustrial pioneering 

Labor as an overhead cost, 15, 20-21, 
77-78, 159, 320, 357-85, 402-3, 
463; cost of accidents, 33-34; cost 
to employer, 370-72; five aspects of 
labor cost, 361; guaranteed earnings 
during layoff, 370; nucleus of force 


kept during layoffs, 51; protection of 
labor’s overhead, 377-78; salaried 
force, 370; seasonal cycle on rail¬ 
roads, 279; seasonal fluctuations, 
160; training as a specialized invest¬ 
ment, 362-63; turnover of labor, 51 

Labor clearing-house, 158, 160; labor 
exchanges, 369; see Employment 
offices 

Labor: partnership in industry, 379, 
412, 482; requisite to perfect social 
accounting, 403 

Labor-saving machinery, 108; see Fac¬ 
tory, Size of plant, Investment, 
growth of 

Labor turnover as motive to regulariza¬ 
tion, 169 

Laborers vs. machines; how their costs 
behave, 7-9, 106, 152-53, 171-72, 
384; cf. Iron Slave 

Large-scale production, see Size of plant, 
Combination 

“Leaders,” 62, 429 

Life of highways, 303, 306-7; see also 
Depreciation 

Load-factor, 15, 172; in capital-pro¬ 
ducing industries, 389; on farms, 346; 
in public utilities, 150, 319, 329; see 
also Business rhythms, Fluctuations, 
Peak-load, Unused capacity 

Long-lived equipment: requires long 
look ahead, 190-91 

Long-run vs. short-run equilibrium of 
supply and demand, 173 

Long-run vs. short-run variation of 
costs, 43-44, 85,105, 107-10, 113, 250, 
259, 282, 323; distinguished by sta¬ 
tistical method, 223, 260-80; effect 
on competition, 308-9 

Longshoremen’s work stabilized, 382 

“Lump of labor” in times of depression, 

364 

Machine rate as basis for allocating 
burden, 249 

Machines vs. laborers, how their costs 
behave, 7-9, 106, 152-53,171-72, 3 8 45 
cf. also Iron Slave 

Machines vs. tools, 106 

Maintenance and replacements: con¬ 
centration vs. regularization of, 55- 
56; vs. deterioration, 205-6; of 
labor as an overhead cost, 358-89, 
361, 375-76; of motor vehicles, 300 

Management, advantages of size, 123- 
24; disadvantages, 124-26 


498 


ECONOMICS OF OVERHEAD COSTS 


Manufacturing; materials, 339; over¬ 
head costs in, 337-41; shifting and 
conversion of overhead, 338; see also 
Factory, Size of plant; cf. also chap, 
ix, esp. 184-85 

Marginal worth of factors of production, 
467-77; absorbs entire product, 469, 
472-74; of constant factors vs. 
deduction from labor’s contribution, 
469-71, 474-77; and cut-throat com¬ 
petition, 474; in partly idle plant, 
469; of variable factors: absorbs 
entire product, 469, 472-74; wages 
less than labor’s marginal worth, 
474-76 

Market: its allocation of community 
overhead, 372; distorts cost of 
materials, 399-401; nation-wide, 419- 
20; nature of, 459-60; one price in, 
417-18 

Marketing, integration in, 138; mo¬ 
nopoly in, 139-40; see Selling 

Materials, 248-49; when charged as 
cost, 204; distorted by market 
fluctuations, 399-400; loss on holding 
vs. on working up, 249; as a sunk 
cost, 55, 197, 339, 341-42; supply of 
under integration, 137 

Maximum demand, 220; and special 
meters, 327; see also Peak load 

Meat-packing industry, 50, 98, 379, 417 

Mechanical units, size of, 114-18 

Merchandising: economies of size, 343; 
fluctuations in, 150; inelasticity of 
costs, 340-42; overhead costs in, 
339-43 

Meters measuring peak-responsibility, 

327 

Minimum price dependent on discrimi¬ 
nation, 195; in railroad rates, 281-82, 
293; see also Differential cost 

Mobilization of labor, 157-58; vs. 
filling in idle time, 365; implies un¬ 
employment, 367; organizing the 
market, 369; see also Employment 
offices, Labor clearing-house 

Monongahela River, 302 

Monopoly, 12, 82, 84, 105, 139-40, 
142-46; burdens of, 144-45; cost of 
establishing, cf. wastes of competi¬ 
tion, 143-44; in research, 144; 
patents, 145 

Monopoly price vs. competitive price, 
417-18, 421, 441; ambiguous con¬ 
dition, 423, 435 

Moral limitations on competition, 440, 
442; see also Competition, Co¬ 


operative activities in business, Mores 
of business 

Mores of business, 179 

Motives to combination, 135, 148 

Motor transport, 299-300; revolu¬ 
tionizes highways, 303 

Mutton and wool as joint products, 

98-99 

Nation as a business firm, 375, 451-52, 
cf. 402-3, 408-9 

Navigation: seasonal character, 150-51 

New Leviathan, 487; cf. Iron Slave 

Night rates, 23, 150, 158, 164 

Nucleus of force kept during depres¬ 
sions, 169, 179, 198-99 

Off-peak business, 14, 23, 34, 79, 85,101, 

166- 70, 214, 229, 286; developing vs. 
cutting down the peak, 409-10; 
exempt from capacity costs, 328; 
night messages, 329 

One-price system, 4, 5, 433; cf. also 
Discrimination 

One price in one market, 417-18 

Operating expenses, 14, 46, 105, hi, 
193, 240, 253, 259, 260, 261; increase 
of, 319; statistically analyzed, 265-69, 
273-80; see also Investment, growth 
of 

Organism, business as an, 478-79; see 
New Leviathan, Community vs. 
business view of cost and efficiency 

Output, dimensions of, 207, 210-13 

Overhead Costs—defined, 1; assessing 
and collecting of, 31-34, 302-3; 
cause of intensified fluctuations, 397; 
community standpoint, 16, 19-22, 

167- 70, 182-83, 352, 384-85, 399-403, 
413, 415, 462; early references to, 5, 
6; economies of size and combination, 
336; and efficiency, 17; fixed invest¬ 
ment, 335-36; inelasticity, 336-37; 
in integration, 137, 403; intellectual 
overhead, 337; joint cost, 336; labor 
overhead, 337, 357-85; materials, 
55, I 97, 249, 339, 341-42, 399-400; 
paradox of, 23; proportion of, in the 
consumer’s dollar, 339-40; public 
overhead, 337; shifting and con¬ 
version of, 25-27, 30, 338, 340, 362, 
387, 397-4°!; cf. 402-3; universal 
character, 16, 355-56; see also Busi¬ 
ness cycle, Capacity costs, Constant 
costs, Fixed charges, Indirect costs, 
Joint costs, Residual costs 


INDEX OF SUBJECTS 


499 


Overtime, 40, 56-57, 270; allocation 
of, 246-47 

Packing-houses: joint cost in, 50, 98; 
regularization of receipts at, 380 

Partnership of government in industry, 
457-58 

Partnership of labor in industry, 379, 
412, 482; requisite to perfect social 
accounting, 403 

Patents, 145 

Peak, reduction saves investment, 203 

Peak-load, 14, 79, 101, 167, 214, 220, 
273-76, 279, 283-86, 322, 326-28, 
343, 348; and casual labor, 368; 
costlier than accounts show, 203, 
279, 283-85; daily vs. seasonal peaks, 
322-24; handled by occasional work¬ 
ers, 159; and investment, 437; see 
Capacity costs, Fluctuations, Load 
factor 

Periodicity in business, 149; see also 
Business rhythms 

Perishable products, 399 

Personnel work as affected by size, 123, 

133 

Petroleum and its joint products, 98-99 

Physiological view of fatigue, 356-59; 
physiological working day, 359-60 

Piecemeal expansion, waste of, 104, 119, 

134 

Pittsburgh plus price for steel, 424 

Planning department, 121 

“Plumb Plan” and economies of in¬ 
creased traffic, 295-96 

Postponable work: as a stabilizer, 92- 
93, 272, 409-11; disturbs statistical 
study of costs, 278; see also Capital 
expenditures 

Precedents and decisions as overhead 
assets, 57, 124; do not stand alone, 
214-15 

Price, minimum, dependent on ability 
to discriminate, 195; cf. Differential 
cost 

Price changes: complicate tracing of 
costs, 260-61; distort cost of ma¬ 
terials, 399-400 

Prices, 2-6, 11, 353; and human values, 
460; maintenance of, 131; means of 
regularizing demand, 163-65; min¬ 
imum paying price, 349; not utterly 
uncontrollable, 485; one price in one 
market, 417-18; steadying prices vs. 
steadying production, 403-7 


Professionalized amusement a cause of 
business rhythms, 153, 171 

Profits of promotion as motives of com¬ 
bination, 135-36 

Promotion, profits of, 135-36 

Propaganda as means of regularizing 
demand, 163 

Proportion of factors, law of, 73-79; an 
example, 472; five stages, 86-90; 
and growth of capital, 413-14; and 
plants working at part capacity, 87- 
88 

Proportion of products, see Joint prod¬ 
ucts 

Public industry as remedy for unused 
capacity, 448-49 

Public utilities, 14, 34, 101, 126, 318-34; 
breakdown service, 326; changing the 
distribution of demand, 328-29; con- „ 
sumer, output and capacity costs, 
322-24; efficiency, economic vs. 
technical, 334; fair return and 
efficiency, 332-34; Hopkinson and 
Wright systems, 324-26; limits on 
differentiation, 323; meters, 327; 
rates, 318, 322, 329; standards of 
efficient performance, 333; see also 
Electrical current, Telephone and 
telegraph, Street railways, Gas 

Public works as preventive of un¬ 
employment, 410 

Railroad equipment, as disturbing 
agency, 394-96; as stabilizing agency, 

411; haulage costs and distance, 
289-90, 291-92; rates, 281-97; 

charging less for the longer haul, 
when justified, 294-95; charging 
what the traffic will bear, 281, 293; 
distance, 289-90, 291-92; a labor 
analogy, 370; and water competi¬ 
tion, 316 

Railroads: and overhead costs, 9, 45, 
51-52, 84-85, 94, 104-5; adapta¬ 
tion of plant to traffic, 109-13; and 
canals, comparative costs, 315; cen¬ 
tral cause of economy, 265; classifica¬ 
tion, 290-91; commodity rates, 291; 
costs: behavior, 258-80; cost system 
of rates, 290; growth of equipment, 
262-63; and highways: total budgets 
compared, 300; rates and profits, 
295-96; seasonal rhythm, 152, 161; 
terminal costs, 288-89; terminal vs. 
haulage service, units of measure¬ 
ment, 211-12; of trainloads, 264; 
see also Rates: railroad 


5 °° 


ECONOMICS OF OVERHEAD COSTS 


Rates: control of, and efficiency, 333- 
34; limits on differentiation, 323; 
public utility, 318, 322, 326; rail¬ 
road, 281-97; “ readiness- to-serve” 

system, 324-27; scientific systems, 

324 

“Readiness-to-serve,”324-27,465; Hop- 
kinson system, 324; in case of idle 
labor, 467; Wright system, 325-26 

Red Queen, 391 

Regularization of industry, 56, 160-71, 
372; in coal mining, 349-52; of farm 
work, 98; limitations of, 279, 280; 
motives to, 159-71; of street car 
travel, 153; in public utilities, 328- 
29; and steadying prices, 404-6; 
through diversity of consumers’ 
peaks, 126-27; through making to 
stock, 155, 161; see also Incentives 
to regularization 

Relieving of destitution, 407; see also 
Charity 

Remnants and “stickers,” 427 

Renewals of durable goods, concentra¬ 
tion of, 154; cf. Capital expenditures, 
Derived demand 

Repair work: economized in large plant, 
127; example of proportion of factors, 
75-76 

Research: an advantage of size, 119; 
community organization of, 123; 
monopoly in, 144; one-sided, 122; 
see also Intellectual overhead 

Reserves: against depression, 155-56; 
to maintain idle labor, 362, 378, 380- 
Si 

Residual costs, 49-50, 292, 478 

Responsibility for overhead costs, 32, 
1:57—58, 170, 211, 218, 220, 221, 244, 
326-28, 411, 478; for democratic 
participation in the problems of 
industry, 482; for direct costs, 247, 
249, 329; for labor’s overhead, 372, 
376-77, 381-82, 384, 409; responsi¬ 
bilities and incentives, 485 

Retailer, shrinks sales by shrinking 
purchases, 400-401 

Revolution by free contract, 482-83 

Risk partly a function of investment, 
191 

Roads, costs of haulage, cf. railroads, 
109; see also Highways 

Rogers, H. H., 110 

Rotation of crops, 98-99, 103 

Routine administration, evils of, 124-25 


Rhythms in business, 149-74; benefits 
of, 156-57; climate and custom as 
joint causes, 154; compensation for, 
171-72; predictability, 155; reme¬ 
dies, 159-61 

Salaried force as overhead, 370 

Salvage value of plant, 180, 200; of 
seasonal goods, 342 

Sault Ste. Marie Canal, 302 

Savings from enlarged equipment, 109; 
see Size of plant 

Scientific management, 121 

Scrapping equipment; cost of, 191-92, 
200, 333 - 34 ; see Abandonment, 

Salvage value 

Seasonal fluctuations, 98, 101, 127, 
159-61; on railroads, statistically 
studied, 273-80 

Seasonal freight rates, 280, 285-86 

Seattle longshoremen, an example of 
stabilization, 382 

Selling: advantage of a full line, 80, 
81-82, 97; bargaining advantages vs. 
productive economies, 122; integra¬ 
tion in, 138; intensive cultivation of 
the market, 130; and mores of busi¬ 
ness, 167; of off-peak products, 162- 
66; as overhead, 59-63; size and 
utilization of market knowledge, 121- 
23; specialization vs. integration, 
24-25; wastes of, 143 

Services: facilitate discrimination, 167; 
supply and demand identical, 464-65 

Shifting and conversion of overhead 
costs, 25-27, 30, 338, 340, 362, 387, 
397-401; cf. 402-3; a cause of 
business cycles, 387, 397-401; and 
community action, 340; illustrated 
by imaginary integration, 402-3; 
insurance as, 30, 381 

Short-run vs. long-run variation of 
costs, 43-44, 85, 105, 107-10, 113, 
259, 282, 323; distinguished by sta¬ 
tistical method, 223, 260-80; effects 
on competition, 308-9 

Shutdown costs, 54, 182; problem not 
ended by bankruptcy, 199 

Side line, 179, 199-200 

Size: advantages of, balanced by 
special services, 140-41; “checks and 
balances” necessitated, 125, 131; and 
class hostility, 132; economies depend 
on human choice, 117; of electrical 
equipment, 319-20; of farms, 88-89; 


INDEX OF SUBJECTS 


and financing, 131; and flexibility, 
320; hypothetical case, 177, 181, 
189-91; limited by organizing power, 
117; of locomotives and cars, 265; 
and marketing economies, 130; of 
mechanical units, 114-17; in mer¬ 
chandising, 343; motives to ex¬ 
pansion vs. economies realized, 104- 
5; of orders, 195-96; of plant, 24, 
81, 88, 104-34; and proportion of 
factors, 89, 338; in public utilities, 
318-21; of repair facilities, 265-66; 
routine administration, 124-25, 131; 
and standardization, 97; telephones 
an exception, 321; and the traditions 
of the service, 133; of transport in¬ 
dustry, 298-302; and unemploy¬ 
ment, 130 

Slow workers and overhead costs, 367- 
68, 478 

Small-scale production: gives steady 
employment, 130; needs aid of large- 
scale research, 121, 140-41, 337, 347 

Social assets damaged by industrial 
advances, 122 

Social cost-keeping, 27-29, 403, 462, 
485; apportioning of overhead costs, 
31-32; burden of unemployment, 
37°» 383, 384; and co-operative 
organization, 411; integration has 
favorable effect within limits, 403; 
requisite to socialist state, 31 

Specialization, 24-25, 140; of plants, 
97, 142; specialized training as 

immobile capital, 362-63; see also 
Standardization 

Spoiling the market, 167-68, 420, 439- 
44; for labor, 363, 377 

Stabilized dollar, 412 

Standard burden rate, 243, 251-54; 
as solvent for labor unrest, 254 

Standard rate of output, 64, 65; see 
Standard burden rate 

Standardization, 80, 81, 96-98; facili¬ 
tates making to stock, 155; stand¬ 
ardized systems of operation, 120-21 

Standards of cost and performance, 242 

Static state, 465; cf. 479 

Statistical indexes of business condi¬ 
tions, 408, 412 

Statistical view of costs, 37, 69, 216-18, 
223-27, 260; disturbing factors, 260- 
61, 269, 275 

Steadying prices: vs. steadying pro¬ 
duction, 403-7; limiting fluctuations 
vs. preventing them, 406-7 


501 

“Stickers,” 63, 235, 427, 430 

Stock, working to, 155, 161, 164, 400- 
401, 406 

Stocks economized, 127; distance neces¬ 
sitates larger stocks, 130 

Storage as remedy for irregular utiliza¬ 
tion, 161, 164; see also Working to 
stock 

Street railways, load-curve, 150; reg¬ 
ularization, 153 

Sunk costs, 54-55, 180; materials as, 
1 97 > 339, 341-43; in planting crops, 
345 

Surplus, accumulated against depres¬ 
sion, 155-56, 184 

Supply: meaning of, 464; of labor, 
465-66 

Supply and demand: cumulative action, 
389, 413; discrepancies, 374, 465-67, 
478; as guide to economic efficiency, 
463-64; intensified fluctuations, 390- 
96, 406; meaning of, 464; two sides 
of the same thing, 467 

Surplus against depression, 155-56, 184 

Swift and Company: guarantees min¬ 
imum weekly employment, 379 

Taxes as substitutes for prices in raising 
overhead costs, 448-49 

Telephone and telegraph, night mes¬ 
sages, 23, 150, 158, 164; automatic, 
322; conversion of costs, 25-26; differ¬ 
ential rates, 329-30; economy of 
consolidated management, 321; plant 
cost and size, 321 

Terminal costs, 288-89 

Time studies, 121 

Training as a human investment, 362- 
63; specialized training vs. the ex¬ 
ploring faculty, 363 

Transport system as a whole, 298-317; 
essentials of a unified policy, 316-17; 
investment and cost, 299-301; para¬ 
sitic transportation, 303; see also 
Highways, Motor transport, Water¬ 
ways and canals 

Trust laws affect competition, 440 

Unabsorbed burden, 243, 251-52; of 
human overhead, 403 

Unearned burden, see Unabsorbed 
burden 

Unemployment: burden of; estimated, 
372; “a cause and not a result of 
depressions,” 371-72, 393 ~ 94 ; com- 


502 


ECONOMICS OF OVERHEAD COSTS 


» 


pensation, 411; concentration of, 368, 
373; and cost of labor, 360-65, 371- 
72; how much necessary? 366-70; 
insurance against, 381, 412, 457; 
labor clearing-house, 160; and output 
per laborer, 93-94, 368-69; penalty 
for dismissal, 381; private vs. unified 
reserves of labor, 382; remedies, 
376-85; result of seasonal cycles, 155 
158, 373 

United Shoe Machinery Co., assumes 
customers’ overhead, 26 

U.S. Steel Corporation steadies prices, 
403-4, 406 

U.S. Sugar Refining Co., 95 

Units of business, 211-13, smallest 
practical unit, 213-15, 281-82 

Unused capacity, 84-85, 87-88, 109; 
on farms, 89; of parts of a plant, 
118-19; see also Capacity factor, 
Idle overhead, Load factor, Utiliza¬ 
tion, Waste 

Utilization: and economy, 84, 90-95, 
104, 158-59; and capacity, 416; vs. 
economies of size, 84—85; 104-5; 
relative importance of capital and 
labor, 159; see also Capacity factor, 
Load factor 

Variable and constant costs, 51-54, 
112-13, 182, 279, 312, 39S-99; inter- 
conversion of, 25-26, 338, 340, 387, 
397-401, 462; cf. 402-3; see also 
Constant costs 

Variables governing efficiency, 79-83 


Vertical combination, 81, 135, 136-41; 
see also Integration 

Vicious circle of unemployment, 372; 
see also Business cycle, Cumulative 
forces in business, Intensified fluctua¬ 
tions, Interdependence 

Virginian Railroad, no 

Wage contract, a faulty division of 
overhead costs, 384, 467; governs 
short-run elasticity of costs, 272; see 
Contracts: forms of 

Wages: adjustment of, to stimulate 
regularization, 377-85; in hypo¬ 
thetical case, 184-85; minimum 
guaranteed, 379-80; necessary living 
cost a minimum, 379; as an overhead 
cost, 370, 371-72; unscientific adjust¬ 
ment, 173; variations in a hypo¬ 
thetical case, 184-85; see also Mar¬ 
ginal worth of factors 

Walworth Manufacturing Co., work of 
regularization, 383 

Wastes: of competition, 143; from 
fluctuations: apparent vs. real, 272- 
73; from idleness, 217, 242; where 
limited by agreements, 446; see also 
Business rhythms, Flexibility, Fluc¬ 
tuations, Idle overhead, Load factor 

Waterways: their overhead costs, 21, 
311-16 

Wool and mutton as joint products, 
98-99 

Working capital, 184-85 

Working to stock, 155, 161, 164, 400- 
401, 406 


PKINTfir* trf THE OJ3.A. 



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